Question

Explain the moral hazard problems associated with (1) deposit insurance and (2) insurance companies. How can they be overcome?

Answer 1

The problem of moral hazard will arise when the people's action will be not replicating the overall cost bearing so they will be taking excessive risk and the cost will be borne by someone else.

Model hazard problem associated with deposit insurance is that when the depositors are depositing the money into the commercial banks and they will believe that these banks are going to protect the money but these banks are unnecessarily lending these money to various risky Assets and these risky assets can sometime default and that can create a moral hazard problem for these people because Bank did not to take full responsibility of its actions and it took excessive risk in order to maximize profit so it is a problem of moral hazard.

Problems associated with insurance companies in respect to moral hazard is that insurance companies will be installing various insured persons who will be taking more risk because they are covered by risk by the insurance company so they will be encouraging a environment of risk taking which can lead to problem of moral hazard.

The problem of moral hazard can be controlled through regular monitoring as well as there should be proper incentive and there should be proper rewards so that this parties involved do not engage themselves into these issues so it can lead to complete mitigation of moral hazards by proper proactive management