Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Getting Away with Excessive Risk-Taking: Moral Hazard


In This Chapter


Introducing moral hazard


Saving the world with bailouts


Spotting the incentives to behave badly


Discovering that threats must be credible to be believed
The media has been filled with stories about bankers’ bad behaviour over the last few years: Libor fixing, subprime lending and foreign exchange manipulation – sometimes the list seems endless. In good economic times, policy makers and perhaps even the public may be willing to ‘let some things slide’. But the part that this behaviour played in the 2008 financial crisis means that any hint of a ‘free pass’ has been abruptly cancelled.

The problem is one of moral hazard – where people are more likely to behave badly in a situation in which they think they can keep their actions hidden from others. In essence, if the likelihood of them being caught or punished is low or nonexistent, some people will take the chance, ignoring any wider risks that may be involved.

As a result of bankers’ excessive risk-taking and the subsequent financial collapse, governments have had to use public funds to bail out some enormous and previously highly profitable companies.

In this chapter, we discuss why bankers sometimes end up behaving badly and why financial institutions take excessive risks, as well as the difficulties policy makers have in tackling the problem.

Banks Behaving Badly: Watching Out

for Moral Hazard

Moral hazard matters (who says economists beat around the bush). Not only does an understanding of it help you to grasp one of the underlying causes of financial instability, but it also allows you to see more generally when markets (not just financial markets) work well and when they don’t.

Moral hazard refers to a situation in which people are able to hide their actions. For this reason, it’s sometimes called the problem of hidden action. Unsurprisingly, when people’s actions are hidden from others, they may have incentives to behave badly.

Just imagine what would happen at your local supermarket if the owners couldn’t tell whether people had paid for their groceries or not. Unless you live in an unusually honest area, large amounts of food would ‘go missing’ in such a supermarket!

Moral hazard has become increasingly linked to the financial system following the 2008 crisis and a series of damaging scandals. For example, a widely held view is that banks knowingly took on excessive risk in the prelude to the crisis because they understood that, in the event of a crisis, they would be bailed out by taxpayers.