Question

What are some examples of moral hazard problems in bank lending? How do regulators act to prevent these problems?

Answer 1

  Moral hazard is a risk that the borrower might engage in activities that are undesirable from the lender's point of view because they make him less likely to pay back a loan. It occurs when the borrower knows that someone else will pay for the mistake he makes.

It is the risk that a party has not entered into a contract in good faith or has provided misleading information about its assets, liabilities, or credit capacity

Examples of Moral hazard in Banking

1.Governments promising to bail out loss-making banks can encourage banks to take greater risks.

2.Comprehensive insurance policies decrease the incentive to take care of your possessions

Regulators should act to prevent these problems

1. Penalise bad behaviour. The government could bail out banks, but penalise those responsible for making the reckless decisions. In the case of Greece, bailout funds are being given very reluctantly and with conditions to reform and pursue austerity.

2. Build in incentives. To avoid moral hazard in insurance, the insurance firm will design a contract to give you an incentive to make you insure your bike. This is why they will not insure for the full amount. Usually you have to pay the first £50 of an insurance claim. Insurance firms also make the process of getting money difficult. This means that you become more reluctant to make claims and so will try to avoid having your bike stolen in the first place.

3. Performance related pay. To avoid moral hazard in the labour market, there can be some form of performance evaluation and no guarantee of a job for life.

4. Split up banks so they are not too big to fail. The problem occurs when banks with consumer savings also take on risky investments. It is the risky investments which need a bailout.