What are the Most Effective Ways to Reduce Moral Hazard?

Moral hazard, essentially, is risk-taking. Generally, moral hazard occurs when one party or individual in a transaction takes risks knowing that, if things don't work out, another party or individual then suffers the burden of the adverse consequences. The disservice to the second party can occur in the course of the transaction, to get the transaction to occur, and even after the transaction has taken place. There are several ways to reduce moral hazard, including incentives, policies to prevent immoral behavior and regular monitoring.

At the root of moral hazard is unbalanced or asymmetric information. The party taking risks in a transaction has more information about the situation or intentions than does the party that suffers any consequences. Generally, the party with extra information has more motivation or is more likely to behave inappropriately to benefit from a transaction. The benefit of the asymmetric information often occurs after the transaction has concluded.

Examples of Moral Hazard

Moral hazard occurs in different types of situations and different arenas. In the financial sector, one motivator can be bailouts. Lending institutions tend to make their highest returns on loans that are considered risky. They are more inclined to make such loans when they have the assurance or expectation of some sort of government aid in the event of loan defaults.

Mortgage securitization can lead to moral hazard—and it did in the subprime meltdown and financial crisis of 2008. Originators of mortgages can pool the loans and then sell pieces of this mortgage pool to investors, thus passing the risk of default on to someone else. In such a situation, it benefits the buyer or buying agency to be diligent in monitoring the originators of the loans and in verifying loan quality.

In the health insurance market, when the insured party or individual behaves in such a way that costs are raised for the insurer, moral hazard has occurred. Individuals who don't have to pay for medical services have an incentive to seek more expensive and even riskier services that they would otherwise not require. For these reasons, health insurance providers generally institute a co-pay and deductibles, which requires individuals to pay for at least part of the services they receive. Such a policy and usage of deductible amounts is an incentive for the insured to cut down on services and to avoid making claims.

Moral hazard in one of its most basic form occurs when employees shirk responsibility at their places of employment. An employee has a basic incentive to do the least amount of work for the same amount of pay. It benefits the employer to cut down on this moral hazard. The employer may establish incentives that encourage employees to accomplish an above-average workload. For example, the offering of bonuses (which may be cash or company stock) for completing a certain number of tasks or for generating more business can serve to steer employees in the direction of desirable behavior and away from undesirable behavior. It also behooves employers to offer long-term benefits designed to motivate employees to be productive and loyal.