Friday, January 16, 2009

Key Concept - Moral Hazard

Moral Hazard is the tendency for a party that is shielded from risk to behave differently than if he was exposed to said risk. It can also occur when a party to a transaction has not entered into the contract in good faith, has provided misleading information about its assets, liabilities or credit capacity, or has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles.

Moral Hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions.

While the concept has been around since the 1600s, the phrase was first used in a modern context in 1963 by economist Ken Arrow. It has been employed in finance to describe the dilemma that arises when a government helps a financial institution rebound after a self-inflicted failure. The unfortunate consequence is that the government assistance could be interpreted as a new precedent - rather than a one-time occurrence - and lead to increased risky behavior by multiple parties.

The concept has been commonly applied in the fields of finance, insurance, management, and in the social sciences.

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