Moral Hazard

A Financial, Legal, and Economic Perspective

Juan Flores Zendejas, Norbert Gaillard, Rick Michalek, Juan Flores Zendejas, Norbert Gaillard, Rick J. Michalek, Rick Michalek, Juan Flores Zendejas, Norbert Gaillard, Rick J. Michalek

• Publisher: Routledge
• Year: 2021
• Print ISBN: 9780367688332
• eBook ISBN: 9781000515022
• Topic: Economics
• Subtopic: Insurance
• Index: Economics

Moral Hazard is a core concept in economics. In a nutshell, moral hazard reflects the reduced incentive to protect against risk where an entity is (or believes it will be) protected from its consequences, whether through an insurance arrangement or an implicit or explicit guarantee system. It is fundamentally driven by information asymmetry, arises in all sectors of the economy, including banking, medical insurance, financial insurance, and governmental support, undermines the stability of our economic systems and has burdened taxpayers in all developed countries, resulting in significant costs to the community. Despite the seriousness and pervasiveness of moral hazard, policymakers and scholars have failed to address this issue. This book fills this gap.

It covers 200 years of moral hazard: from its origins in the 19th century to the bailouts announced in the aftermath of the COVID-19 outbreak. The book is divided into three parts. Part I deals with the ethics and other fundamental issues connected to moral hazard. Part II provides historical and empirical evidence on moral hazard in international finance. It examines in turn the role of the export credit industry, the international lender of last resort, and the IMF. Finally, Part III examines specific sectors such as automobile, banking, and the US industry at large.

This is the first book to provide an interdisciplinary analysis of moral hazard and explain why addressing this issue has become crucial today. As such, it will attract interest from scholars across different fields, including economists, political scientists and lawyers.

1 Moral hazard, a long-term perspective and challenges ahead

Juan Flores Zendejas, Norbert Gaillard, and Rick Michalek

DOI: 10.4324/9781003139249-1

Moral hazard is an elusive, yet commonly used term. An analysis of its origins and its diverse applications in different fields shows its theoretical and empirical relevance. This chapter introduces the main questions relating to moral hazard, beginning with the academic literature on insurance and finance. It provides a brief overview of the main challenges that have been raised in the context of moral hazard. It shows how public authorities have adjusted many of their decisions to intervene in the economy due to fears of moral hazard. Nevertheless, this chapter claims that moral hazard remains a major challenge for governments worldwide, given the financialization of the economy and the concentration of industry in different sectors. Moral hazard may lead to unintended and even perverse outcomes for societies, and thus, remains a major issue for scholars and policymakers.

In the Iliad, when Prince Paris of Troy decided to seduce Helen, queen of Sparta and wife of King Menelaus, he probably did not expect such an act to trigger a ten-year war between the two states. Paris’s reckless behavior might have been related to his noble origins, leading him to believe that he was permitted to act as his willingness dictated. Another possibility, however, was the support granted by goddess Aphrodite, who had offered Paris the possibility to have the love of the most beautiful woman on earth. With this dream in mind, and with his back covered by Aphrodite, Paris’s rash judgment might have been easily explained.

Some of today’s economics texts would provide a straightforward explanation of Paris’s behavior. Paris was exposed to moral hazard, a term now commonly used in contexts of asymmetric information. In the Iliad, Menelaus kindly welcomed Paris into his Palace. He did not know, nor could he know, about Paris’s obscure reasons for his visit. Admittedly, ancient Greek relations between gods and humans might be more complex than today’s concepts of divinity. Moreover, the struggles between Menelaus and Paris would more likely be considered a soap opera and would not trigger endless academic discussions. However, the example illustrates how the concept of moral hazard can encompass social, political, or economic interactions. Fortunately, not all moral hazard situations end up in armed conflicts.

Section 1 What is at stake?

According to the Oxford Dictionary, moral hazard can be defined as the “lack of incentive to guard against risk where one is protected from its consequences, e.g., by insurance.”¹ While there is no consensus about the precise origins of the term, there is no doubt that it was largely preceded by situations in which individuals were confronted with moral hazard.² For at least the past two hundred years, scholars from different fields have analyzed, through a variety of approaches, the behavior of individuals, banks, and firms when facing situations of moral hazard. In fact, moral hazard might be present in all human actions (Emmett, 2011, p. 1150). This claim can be directly attributed to the fact that human interactions are characterized by uncertainty, and thus, individuals seek naturally to shift the burden from the consequences of their decisions onto others (McCaffrey, 2017). Yet, it is noteworthy that economists have devoted the most time analyzing the causes and consequences of moral hazard.

A rapid overview of moral hazard as an issue in the economic literature serves to understand why economists are so concerned. One major reason is the fact that moral hazard may create unnecessary costs to society and lead to distortionary effects. To give but the most illustrative examples of the kinds of moral hazard identified in the literature, we could mention the banking sector, government welfare programs, the automobile industry, and, of course, the insurance sector. Today’s most commonly used theoretical framework underlying the problem of moral hazard is the neoclassical principal-agent theory (Mas-Colell, 1995). This theory attempts to describe a situation in which a principal hires an agent to accomplish a task. The principal and the agent have a different set of preferences. More importantly, the agent possesses superior information about the transaction (hidden information). The agent is also in a position where it could take actions that are unobservable to the principal (hidden actions). As a result, the principal cannot verify whether the agent acts according to what was agreed upon in the first place.

While problems of hidden information are frequently referred to as adverse selection, our view is that moral hazard involves situations of hidden actions.³ Moral hazard reflects the agent’s incentive to engage in [hidden] risky behavior offering a greater reward when it is (or believes it will be) protected from negative consequences, whether through an insurance arrangement or an implicit or explicit guarantee system. It is precisely in the insurance industry where scholars have mostly identified historical narratives on concerns relating to moral hazard. A first example dates back to the 11th century, when the losses that could be insured by a mutual-aid society in feudal France explicitly excluded covering losses that resulted from the negligence of the claimant (Moss, 2004). It is not surprising that the design of insurance contracts has been accompanied by endless discussions about the impact on an individual’s disincentive to exercise caution, while increasing the proclivity to engage in careless or risk-seeking behavior (Djelic and Bothello, 2013, p. 592). Despite these concerns over individuals’ misbehavior, the insurance business has expanded in both the public and the private sectors since the mid-19th century.⁴

Kenneth Arrow is now considered one of the most important contributors to the literature on moral hazard that emerged in the 1960s and 1970s. His first research works addressed medical insurance issues (Arrow, 1963) but his conception of moral hazard was not necessarily the one that is the most widely used today in the literature (Grignon et al., 2018). The variety of perspectives has led the insurance literature to distinguish between ex ante moral hazard – where an agent responds to changes in incentives by altering behavior affecting the risk of losses – and ex post moral hazard, which focuses on the effects of incentives – and disincentives – on claiming losses.⁵ This distinction is relevant for understanding insurance contracts that do not necessarily prioritize minimizing the likelihood of having an accident, but rather reducing the amounts payable on insured claims.⁶

Another sector where moral hazard has been at the core of disputes is the financial sector. The emergence of entities having the capacity to provide lender-of-last-resort services triggered debates on their attitudes toward the riskiness of the projects that they decide to finance. Today, this issue involves primarily central banks, public entities, and multilateral organizations. It is interesting to note that when private entities provided such services, the mechanisms designed to eliminate moral hazard were not very different than those conceived by central banks in present times. These similarities are best illustrated in events during the 19th century.

In Britain, the evolution of the regulatory framework in the first decades of the 19th century prevented the Bank of England from acting on behalf of the British banking sector. In particular, the Bank Charter Act of 1844 imposed a 100-percent reserve on the Bank of England, thereby impeding the Bank from intervening in periods of financial difficulties (Fetter, 1965). This act had to be suspended given the gravity of the crises of 1857 and 1866. However, in order to avert moral hazard, the Bank of England reacted by gradually raising the quality requirements of the paper that could be utilized as collateral. The Bank also improved the information it held on potential users of their liquidity facilities (Bignon et al., 2012).

The U.S. banking system operated without a central bank during most of the 19th century. Clearing houses emerged as key actors that managed the co-insurance mechanisms to prevent contagious bank runs. Clearing houses acted as regulatory and supervisory agencies, and thus relied on a set of instruments that forced banks to respect certain basic, risk-management prescriptions (Winkler, 2011). Membership to this insurance mechanism was most useful for weaker banks that were more prone to engage in morally hazardous behavior (Dowd, 1994).

Yet, none of these frameworks sufficed to prevent occasional financial crises, nor even to completely mitigate moral hazard problems. In both cases, the institutional framework was to be either complemented by emergency measures (e.g., the 1890 Baring rescue in Britain) or even completely reformed as in the United States following the 1907 financial crisis, which led to the establishment of the Federal Reserve in 1913.

A long-term perspective on the 20th century tells a similar story. The fears arising from moral hazard appeared frequently in the aftermath of major financial crises. The introduction of the Federal Deposit Insurance Corporation (FDIC) aiming at protecting the “people’s cold, hard-earned cash” drew criticism by the U.S. President F. D. Roosevelt as it would lead to “laxity in bank management and carelessness on the part of both banker and depositor” (Prins, 2009, pp. 138–139). Even so, Roosevelt signed the Glass-Steagall Act in June 1933, thereby implementing the deposit insurance scheme of which the FDIC would be in charge. Deposit insurance was designed to protect the interest of depositors and prevent banking runs, but moral hazard problems did not take long to materialize (see Grossman, 1992).

The debates that accompanied the failure of banks in the aftermath of the Bretton Woods collapse (see Schenk, 2014) suggest that moral hazard was becoming a key issue. In 1975, three economists – Paul Horvitz (director of research at the FDIC), Thomas Humphrey (economist at the Federal Reserve of Richmond), and Thomas Mayer (professor at the University of California, Davis) – wrote three independent articles in which they concluded that the rescue of banks was now among the top priorities of U.S. regulators. Mayer (1975, p. 604) even considered that “in the case of very large banks, it is widely believed, and probably correctly so, that the government would not allow them to fail, i.e., would not let them go into receivership.” Such views proved prescient.⁷ In 1984, after the Continental Illinois bank was bailed out by the Federal Reserve Bank of Chicago and the FDIC, the Comptroller of the Currency testified to the Congress that U.S. regulators would not let the top eleven multinational money center banks fail. In response, Congressman Stewart McKinney exclaimed that they had thus created a new kind of bank: the “too big to fail” (TBTF) bank.

This new environment had two noxious consequences that contributed to nurture moral hazard. First, financial institutions started a race to bigness in order to obtain the TBTF status and increase the likelihood to be rescued in the event of a severe crisis (Wilmarth Jr., 2002). Second, U.S. regulators, credit rating agencies (CRAs), and the Federal Reserve exacerbated (and are still exacerbating) the problems inherent to the TBTF phenomenon: financial sophistication, underestimation of credit risk, and growing indebtedness (Gaillard and Michalek, 2019). It seems clear that top policymakers accommodate TBTF banks not only for reasons of political campaign support but because they enable constituent households to maintain their standard of living and firms to continue their leverage strategies. In a nutshell, moral hazard would be the price to pay to preserve political survival, economic growth, and more fundamentally, to prevent systemic risk.

There are, however, dissonant perspectives, and one may wonder whether moral hazard constitutes a problem at all. The growth of the financial sector might have been unavoidable and its relevance in the development of today’s rich countries has been recognized in the literature (Rousseau and Sylla, 2003). The history of financial institutions and capital markets has demonstrated that investors and banks have found different mechanisms to monitor their investments and have a voice in the decision-making process of the firms being financed (DeLong, 1991). The victory of finance has been connected to the victory of capitalism, and success stories of strong collaboration between banks and enterprises have been found in Western Europe, the Unit...

Table of contents

• Cover
• Half Title
• Series Page
• Title Page
• Copyright Page
• Contents
• List of Illustrations
• Editors
• List of contributors
• 1 Moral hazard, a long-term perspective and challenges ahead
• Part I Conceptual and theoretical aspects of moral hazard
• Part II Moral hazard and sovereign risk
• Part III Moral hazard in the financial and corporate areas
• Index