Moral Hazard

Moral hazard is the risk that a party protected from the consequences of its actions will behave differently, usually more recklessly, than it would if it bore the full cost. An insured driver may park less carefully, a borrower who has little of their own money at stake may gamble with a loan, and a bank that expects to be rescued may take on more leverage. The term comes from nineteenth-century insurance practice, where it originally carried a sense of moral failing; economists now use it in a neutral, technical sense.

Moral hazard is a problem of hidden action after a contract is agreed, which distinguishes it from adverse selection, a problem of hidden information before the deal. Both stem from asymmetric information. Moral hazard is closely tied to the principal-agent problem, in which one party acts on behalf of another whose effort it cannot fully observe, and it is a constant concern in the design of insurance, banking regulation and crisis policy.

Think about borrowing a friend's car compared with driving your own. Most people are careful either way, but with a borrowed car a few might take the speed bumps a little faster, knowing the repair bill is not theirs. Nothing about the person has changed; only who pays has.

Moral hazard is that shift in behaviour. When a safety net takes away some of the cost of a bad outcome, people have a little less reason to avoid it. The challenge is to keep the safety net's benefits without encouraging the careless behaviour it can invite.

Kenneth Arrow analysed the issue in health care in 1963, and Mark Pauly showed in 1968 that full coverage can raise the use of medical services simply because they become cheaper at the point of use. The RAND Health Insurance Experiment, run in the United States between 1974 and 1982, randomly assigned families to plans with different levels of cost-sharing and found that people facing higher out-of-pocket costs used less care, with little measurable effect on health for the average participant. Insurers manage the problem with:

• Deductibles and co-payments, which keep part of each loss with the policyholder.
• Policy limits and exclusions for losses the policyholder can easily cause.
• Monitoring and conditions, such as requiring alarms or telematics devices in cars.
• Experience rating, which raises future premiums after claims.

Financial safety nets create some of the largest moral hazard debates.

• Deposit insurance. Deposit insurance prevents bank runs but reduces depositors' reasons to watch their bank. Coverage is capped, at $250,000 per depositor per insured bank in the United States, €100,000 in the EU, and £120,000 in the UK under the FSCS since 1 December 2025, and banks pay risk-based premiums and face capital rules such as Basel III.
• Bailouts and "too big to fail". If large institutions expect government rescue, creditors may lend to them too cheaply and the institutions may take excessive risk. The rescues of the 2008 financial crisis, including the US Troubled Asset Relief Program authorised at up to $700 billion in October 2008, intensified this debate. Reforms such as the Dodd-Frank Act of 2010 and bail-in rules aim to make shareholders and creditors bear losses before taxpayers.
• Central bank support. The role of the lender of last resort has long been framed around moral hazard; Walter Bagehot's 1873 rule to lend freely, against good collateral, at a high rate was partly designed to limit it.
• Securitisation. When lenders sell loans on through securitisation, they may screen borrowers less carefully. Post-crisis rules in the US and EU generally require securitisers to retain 5% of the credit risk, giving them skin in the game.
• Sovereign lending. Critics argue that IMF rescue packages can encourage reckless lending to governments; defenders reply that conditionality and the cost of crises limit the effect.

Common approaches include making the protected party share in losses (deductibles, co-investment, collateral), monitoring behaviour, linking rewards to outcomes through incentive contracts, building reputation through repeated dealings, and setting clear rules in advance about who will bear losses. In corporate settings, these tools overlap with efforts to reduce agency costs, such as tying executive pay to long-term performance and clawing back bonuses after misconduct.

Economists disagree about how much moral hazard matters in specific cases. In health care, some argue that cost-sharing deters necessary as well as unnecessary treatment, especially for low-income patients, while others stress its role in controlling spending. In finance, some economists and policymakers argue that crisis rescues are needed to prevent a wider collapse, given systemic risk, and that the economic damage of letting institutions fail outweighs the incentive costs. Others, including many in the Austrian and free-market traditions, argue that repeated rescues teach markets to expect protection and so make future crises more likely. Most policy frameworks now attempt a middle path: providing support in emergencies while imposing costs on those rescued.

• FDIC: Deposit Insurance
• Bank of England: PRA confirms FSCS deposit limit increase to £120,000