The chapter “The Problem of Moral Hazard”

The chapter “The Problem of Moral Hazard”

The chapter “The Problem of Moral Hazard” begins with a case study of the Progressive Direct Group of Insurance Companies. The group introduced a device that evaluates drivers’ driving habits, including their mileage, top speeds, and use of brakes to offer insurance plans. According to the group’s logic, promotional incentives to careful drivers would reduce the cost of damages that the insurers would have to pay in case of an accident. While this example appears to be a typical case of the problem of adverse selection, its rationale is grounded in the moral hazard problem of insurers.

Uninsured people are careful regarding their activities because they understand the pain of paying their bills in case an accident happens. For example, an insured driver will be reckless if his or her plan covers all damages in the event of an accident. The uninsured driver, on the other hand, will be cautious on the road because if he causes an accident, he will have to pay out of his pocket. The incentive to be careful in one’s undertaking reduces significantly when a person purchases insurance, which is the problem of moral hazard.

Further, Chapter 20 explains that unlike the problem of adverse selection, moral hazard deals with a special type of asymmetry – action. When one party in a transaction is unable to determine the behavior of the other party in their absence, they might make a risky decision that might incur them losses. For instance, if a health insurer unknowingly provides coverage to a chronic smoker, the company will likely pay medical bills for the client sooner than expected. However, motivating the patient to avoid risky lifestyle behavior or risk the termination of his policy can be a good step towards minimizing risks in such a transaction.

Companies have adopted several measures to reduce the likelihood of risky behaviors in their transactions with customers. For example, banks require some clients to sign for covenant loans to ensure that they will utilize the loans effectively (Froeb et al., 2018, p. 261). The issue of moral hazard, especially in lending, emanates from a typical human trait that causes borrowers to risk the lender’s money more than they would accept if it were theirs. Without an incentive to exercise care, borrowers might engage in riskier activities that would lead to loan defaults. Moral hazards affect both parties in the transaction. They elicit trust issues between parties who suspect each other of a failure to meet their contractual obligations. Therefore, ensuring that managers and their institutions introduce robust measures to guide transactions and guarantee that all parties will meet their obligations is in their best interests.

The example of a strategy to incentivize against moral hazards is the “all or nothing” principle, in which each party is expected to contribute squarely to the achievement of an agreement or lose all promised rewards. Froeb et al. (2018) provide the example of a salesperson. If the agreement with the management is to receive a certain percentage of sales in addition to a basic salary, the employee is highly likely to perform efficiently. If the employee is sure of getting a basic salary at the end of the month and the earnings from the commissions do not commensurate his efforts, he or she can shirk the sales and wait for the typical basic salary as long as he or she is not monitored. However, if the efforts to sell the products are well-compensated, the employee will gladly fulfill the employer’s wishes. A solution to this problem would be to offer the employee the option of termination or a decent compensation for his or her efforts. Consequently, the incentive will be to conduct the task with minimal supervision. An alternative solution is for the employers to recruit hardworking employees who cannot shirk irrespective of whether they are monitored (Froeb et al., 2018). According to Froeb et al. (2018), such an employee will make more sales because of their proven reputation. Employers can motivate these workers with higher wages since they are valuable to the company. A moral hazard may also hurt both parties in the transaction, for example, in the case of a consulting firm billing a client on an hourly basis (Froeb et al., 2018). Since the customer cannot supervise the consultant’s activities, the client anticipates that the specialist will charge for more hours than expected. Additionally, the consultant may execute tasks that are of no value to the customer (Froeb et al., 2018). Shirking then becomes a more likely result, and the client will be unwilling to transact. In such a situation, both parties can find ways to overcome the moral hazard. For instance, the consultant can avail a document showing the value of work done or develop an excellent reputation to resolve the moral hazard.

Financial institutions, particularly the banks, were on the spot for their role in the 2008 financial crisis. Regulators can minimize the impact of moral hazard by obligating the banks to maintain about 10% equity so they can reimburse depositors (Froeb et al., 2018). With the falling of asset value, the likelihood of maintaining the equity cushion becomes minimal, and the risk of moral hazard escalates. During the last financial crisis, the Treasury’s move to guarantee short term loans encouraged the undercapitalized banks to undertake riskier investments (Froeb et al., 2018). The ultimate result would see the banks keep most of the profits if these investments succeeded, but if they failed, the taxpayers would pay for most of the losses. The absence of mitigating measures allowed the banks to continue making riskier investments. To address this moral hazard, the government had to inject equity into the banks (Froeb et al., 2018). The move further incentivized the financial institutions to continue lending and gave the owners a share in the banks that absorbed the risks of the moral hazard. Besides, the government was able to punish the irresponsible banks by taking a stake in those institutions. Thus, it is likely that financial institutions would make less risky investment decisions in the future as they fear that the government would take more stake in the case of another bailout.

Homeowners’ bailout through foreclosure prevention programs raises similar concerns. Advocates argue that such programs will significantly benefit responsible families prevent foreclosures (Froeb et al., 2018). However, the number of creditors making risky bets on house prices will also benefit. Allowing the creditors to renegotiate their existing loans would increase their rates for new loans. As a result, foreclosure prevention programs punish responsible borrowers twice, which is a moral hazard (Froeb et al., 2018). The remedy would be to carry out a careful assessment so that responsible creditors would not have to pay for higher rates before sanctioning a foreclosure prevention program.

Overall, the problem of moral hazard is always in the banking industry. The banks are less inclined to provide loans to customers who are less likely to repay. Moral hazards were the significant causes of the 2008 financial crisis. These hazards included inadequate transparency in the banks’ transactions as market participants engaged in highly risky bets on the economy. The U.S. Treasury also failed to compel the banks into maintaining their equity. Thus, a compromise solution to preventing moral hazards in the banking sector is to off incentives for institutions that abide by the set financial regulations.