Question

What is moral hazard? How do financial institutions deal with moral hazard?

Answer 1

Answer

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.

Financial institutions like banks can deal with a moral hazard by ensuring that when they provide a loan to a person/firm, that person also has soething to lose if the place/ project where the lent money was invested is lost.

For example- If Mr. X wants to purchase a home which costs $50,000 , then, banks may provide a loan of $40,000 and ask Mr. X to put his own $10,000. This is done to ensure that the problem of moral hazard is not present to a large extent. Thus, if something happens to the house due to the negligence of Mr. X, he will also be losing his $10,000. Thus, this makes Mr. X more careful in managing his house. This keeps the bank's lent amount safe as well.