MORAL HAZARD (Encyclopedia)

The role of banking intermediaries is to "intermediate" between players who are in financial deficit and those experiencing a surplus in order to resolve their need to invest available financial resources. People who are in financial deficit seek monetary resources by placing "liabilities" on the market and by offering them to those in surplus. The problem is therefore to reconcile the preferences expressed by buyers as compared with those made by the issuers of liabilities in terms of maturity, yield, value fluctuation, etc.
Subjects in surplus have difficulties in identifying and evaluating the quality of those in deficit, they must take into account the uncertainty associated with future events, their degree of risk aversion and the preference of short-term assets. On the other hand, those in deficit prefer to issue long term liabilities, not to disclose their quality of credit and, once obtained the funds, they prefer to opt for more profitable but risky projects. 
As a matter of fact, it is rather rare to have a direct transfer of resources from subjects in surplus to subjects in deficit. 
This raises the foundation for the presence of a third party that is able to meet the different needs and to interact by transferring and finally reallocating financial resources within the economic system. Financial intermediaries realise the channelling of savings into investments.
The existence and role of financial intermediaries is explained by the traditional theory that has developed a number of reasons to justify the development of this phenomenon. Among these, we can find the function of evaluating and selecting business projects within the theoretical paradigm of incomplete markets and imperfect information. This theory puts emphasis on the activities of banks by recognising them as critical due to their ability to solve problems of asymmetric information that are relevant to an imperfect market - adverse selection and moral hazard. Thanks to the role played by financial intermediaries, such problems may be partly solved or at least transferred to the same financial intermediaries that have the means to bear any adverse effects, thus avoiding their transfer onto a single or a small number of savers.
Moral hazard is a risk that can occur in a situation ex-post to the provision of funding and which stems from the misconduct of a company to use loans for riskier assets than those declared. This phenomenon is experienced when a company, once obtained a loan for a specific project with a relative degree of specific risk, is encouraged to use the same resources for riskier targets although with a a higher expected return. As to the techniques applicable for the resolution of this problem, we can mention the monitoring activities that the bank uses daily with professional and qualified methods. While a bank, which has acquired all the instruments and the professionalism (goods with a high fixed cost) to conduct a monitoring activity, allocates and redistributes such costs on all projects that are monitored, single economic agents are not in the position of supporting this activity due to the high costs that they should face, such that they would not be able to lend anybody their excess financial resources. From a theoretical point of view, a model was developed by Diamond (1984) who, in the presence of moral hazard, has demonstrated the optimal approach to follow; that is to say, financing investment projects through the activities of an intermediary rather than directly on the market. 

1. Moral Hazard: the case of insurance intermediaries 

In the case of insurance intermediaries, adverse selection and moral hazard occur in different situations. The first phenomenon is usually experienced prior to the signing of the insurance contract, in case the insurer does not have sufficient information to classify its clients into homogeneous classes of risk, namely in classes that are characterized by the same probability of suffering damage that would lead to establish an equal premium for all those insured against the same risk. In such cases, the premium would result in being too high for low-risk individuals and too cheap for those expected as the riskiest, thus generating an accumulation of bad risks and the consequent default of the insurance company. The second phenomenon occurs after the signing of the contract and characterises the actions taken by the insured that lead to change the likelihood of the risk originally estimated by the insurance company or the amount of the reimbursement – such a case is encountered when, being covered by the insurance contract, the insured agents reduce the caution that they would have applied if they had not been secured, thus making  the insured event more likely and its reimbursement higher. 
To counter these problems, the insurance companies may seek to acquire more detailed information on the conduct of the insured agents and to employ measures to discourage and combat these phenomena, by: 
a) segmenting customers into homogeneous risk classes;
b) requiring the signature of insurance for all persons exposed to certain types of risks;
c) involving insured agents in sharing the risk;
d) tying the premium to the history of the person to be secured;
e) reducing the premium if the insured implements special precautions to reduce the probability that the risk occurs.
The first two types of measures tend to contain the phenomenon of adverse selection, whereas the last three types are most commonly used to limit moral hazard by making observing virtuous behaviours cost-effective for the insured. 
Information is therefore essential and the basis of every decision linked to the activities of financial intermediaries. A proper information system is key to the solution/minimization of problems arising from asymmetric information.

2. Moral Hazard: the Principal-agent Case 

In addition, asymmetric information problems (adverse selection and moral hazard) are of particular relevance to the financial intermediaries’ world in the areas of contractual relationships, such as in the definition of optimal contracts between the main player (principal), identifiable for example with a company shareholders' meeting, and the agent (agent), identifiable with the company's CEO. The principal is the one who offers a contract and who is not familiar with the capabilities of the agent to whom the contract is offered. In the case of adverse selection, it is the agent who knows his/her true professional skills, while the principal can only guess them and learn them over time, but only after having signed the contract. The case of moral hazard arises when the agent's actions are not fully verifiable by the principal, something that is justified by the fact that if every action of the agent were to be checked and approved by his/her principal, then his/her role would be unnecessary and represent only an additional cost for the company.

3. Moral Hazard: the case of Akerlof’s lemons 

When dealing with problems of adverse selection and moral hazard, the example most frequently cited and studied in economics is the one developed by George Akerlof in relation to the used car market, which distinguishes cars classified as good from those defined as lemons. Briefly, in this market, only sellers know the quality of the car on sale while buyers ignore their characteristics. If the buyers were aware of which car were good, they would pay the price they would feel reasonable for a good car; but since there are also "lemons", they will pay a price that, based on the probability that the car on sale is a lemon, averages between the price reasonable for a bad car and the one judged as appropriate for a good car. Considering the price lower than the correct one, good car sellers would not be inclined to sell, while sales of lemons would be promoted at a higher price than their value. Considering the trend in sales of lemons, buyers would no longer be inclined to pay the requested price, thereby generating a negative trend in sales, to the point that transactions would decline to zero. This situation generates the need for a third party who acts as an intermediary and has the tools and skills to discharge that function.
Bibliography
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Editor: Alberto Maria SORRENTINO
© 2009 ASSONEBB