| Moral
Hazard |
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Moral
hazard is the risk that a contract will change the behavior of one
or both parties. If I cover you for all of your mistakes, then you
will likely assume more risk than is optimal for both of us.
Risk is a commodity whose potential downside is often shared. If each
risk taker is forced to cover at least part of his own potential losses,
then he will likely act prudently (moral) when taking on risk, and
thereby reduce the potential downside for everyone.
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For
example, if bank owners are not made to cover at least part of the
cost in covering consumer deposits, then the general public will necessarily
assume more risk than is socially optimal. Bank managers will tend
to act carelessly, because they are not compelled to pay for the potential
losses to consumers in the event of bank failure. |
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