How Moral Hazard Influences Investment Decisions

Moral hazard refers to a situation in which an investor, decision-maker, or other actor has an incentive to make what would normally be implausibly or inappropriately risky decisions because they believe they are shielded from the potential fallout of those decisions, either by bureaucratic secrecy, government bailouts, or an insurance policy. The term originates in the insurance industry, but in recent years has become particularly commonplace in discussions of the financial industry and political economy.

In essence, moral hazard eliminates incentives to avoid decisions which a person would normally regard as being unacceptably high-risk. In the insurance sector, it originally referred to people who avoided basic precautionary measures (like checking a fire alarm battery) on the assumption that their insurance coverage eliminated the need for such measures, or who, having received insurance, immediately undertook high-cost activities they would have thought unacceptably expensive beforehand (like pursuing an expensive therapy or treatment after receiving new health insurance which covers that treatment). Note that moral hazard is technically different from outright fraud. Moral hazard simply refers to an altering of the risk-benefit calculations involved in the decisions people make. In contrast, outright fraud is a deliberate manipulation of a system to extract money from somewhere else. A dishonest owner deciding to burn down an unprofitable store to collect the insurance money, for example, is insurance fraud – not simply moral hazard.

In recent years, moral hazard has become a particularly important concern in matters of finance and investing because of the government’s repeated decisions to bail out large investment banks which have got in over their heads through one sort of risky investment or another. Government responses to major financial crises, particularly in the United States but also elsewhere, illustrates a pattern in which very large financial institutions, those said to pose a “systemic risk” (or, more simply to be “too big to fail”) will almost always be bailed out rather than be allowed to go bankrupt.

Were this to occur simply once, or even once in a while (followed by warnings that it would not occur again), the result would be severely objectionable both to liberals opposed to big-business interference in politics, and conservatives opposed to political interference in the markets. However, moral hazard comes in when the event becomes not simply a rare one-off occasion, but evidence of a pattern. Large investors, including banks, regularly face potential investments which they either walk away from, or demand extremely large interest payments from, due to very high risk. The knowledge that a government bailout will in all probability rescue the company in the event that a large number of these very risky bets fail to pay off, it is alleged by moral-hazard theorists, means that banks will take on more of those risky investment decisions than they normally would, in the knowledge that they are shielded from the full consequences of their actions.

Much the same danger is alleged when the government attempts to re-stimulate the economy by, for example, offering guarantees to cover new investing in the event of losses. In such a case, an investor faces all of the potential benefits of a payout, but few of the negative consequences of a loss on the investment (which would be covered by the government).

Even in a pure free-market economy, moral hazard may still affect investment decisions as a result of the diffusion of responsibility. Leading up to the recent subprime mortgage crisis, for instance, many banks and investors were misled into assuming a far greater level of security in their investments than was actually present as a result of complicated networks which seemed to shield them from the consequences of bad investments. Companies that actually gave out mortgages could quickly realize a full return on their investment through securitization, and therefore had less than the normal incentive to ensure that everyone with a mortgage actually had the proper ability to make their payments on schedule. Companies investing in large pools of these mortgages believed the system could reduce risk when it actually could not.

Moreover, those banks which insured their investments or derivatives through the services of companies like AIG then ended up in a classic insurance moral hazard situation, believing that their insurance gave them carte blanche to take unusually risky positions. When too many payouts were demanded from AIG and the insurance company itself became insolvent (then was quickly bailed out by government), suddenly these investors faced an even more painful reckoning. In this situation, arguably, investment banks insuring their positions through AIG faced the classical insurance-related moral hazard, while AIG itself enjoyed a separate calculation influenced by moral hazard, assuming that the government would bail it out in the event that it could not cover all of the policies taken out.

In practice, the level of moral hazard caused by government bailouts is limited by the fact that the government’s own finances and political freedom to intervene in the markets are increasingly limited, and by the fact that the first companies affected in a given crisis are likely to collapse before a rescue can be organized, as occurred with Lehman Brothers. Nevertheless, there are justifiable fears that in the absence of convincing declarations that no new bailouts will occur in future crises, or regulation to prevent such crises from occurring, large banks will in the future undertake increasingly risky investment positions once again, on the assumption that the government will bail them out in the event of fears of a systemic collapse.