Question

Explain moral hazard and give at least two examples. Discuss its implications as an informational asymmetry problem for financial crises.

Answer 1

Moral hazard 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. In addition, moral hazard also may mean a party has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles.

Example:  If an employee has a company car for which he does not have to pay for repairs or maintenance, the employee might be less likely to be careful and more likely to take risks with the vehicle.

Example: Prior to the financial crisis of 2008, when the housing bubble burst, certain actions on the parts of lenders could qualify as moral hazard. For example, a mortgage broker working for an originating lender may have been encouraged through the use of incentives, such as commissions, to originate as many loans as possible regardless of the financial means of the borrower. Since the loans were intended to be sold to investors, shifting the risk away from the lending institution, the mortgage broker and originating lender experienced financial gains from the increased risk while the burden of the aforementioned risk would ultimately fall on the investors.

Historically, financial crises have begun with stock market crash, rise in interest rates and resulting credit spread rather than with a failure of a financial institution, with the latter more likely being a consequence than a cause. The failure of a major financial intermediary however significantly increases the uncertainty in the market. Ceteris paribus, asymmetric information introduces a multiplier effect through which rise in interest rates raises lemons problem in the credit markets, agency problem and value destruction in stock markets. Failing banking institutions make the interest rates rocket, cause the final stock market crash both of which are reflected in the widening credit spreads between high grade and lower grade bonds. The events amplify asymmetric information to the degree where economic growth is halted.