What is 'moral hazard'? How does it manifest in bailouts?

Hi there, the term "moral hazard" isn't as mysterious as it sounds. I'll explain it in simple terms, and you'll get it.

What is "Moral Hazard"?

Imagine you bought a "full coverage" insurance policy for your phone. No matter how it gets dropped or water-damaged, the insurance company will fully compensate you with a new phone, and you won't have to pay a single penny.

At this point, wouldn't you become less careful with your phone? You might toss it casually on the sofa, use it in the rain, or not even bother with a screen protector or case. That's because you know that even if the phone breaks, the insurance company has your back, and you have nothing to lose.

This mindset and behavior – where you act more boldly and irresponsibly because someone else will bear the cost – is what we call "moral hazard".

Simply put, when an individual doesn't have to fully bear the negative consequences of their actions, they are more likely to take risks and act less cautiously.

How is it Reflected in "Bailouts"?

This concept is perfectly exemplified in financial crises and government bailouts, especially concerning "Too Big to Fail" financial institutions.

1. The "Too Big to Fail" Implicit Rule

Giant Wall Street banks, for instance, have complex and intertwined operations that are deeply integrated with the entire economic system. If one of them were to face bankruptcy due to reckless decisions (e.g., investing too much in high-risk products), it could trigger a chain reaction, leading to a collapse of the entire financial system, a major economic depression, and mass unemployment.

The executives at these banks know perfectly well that they are "too big to fail." They develop an expectation: "We are too large; if we go down, everyone goes down. Therefore, the government will have no choice but to rescue us to protect itself."

2. The "Profits for Me, Losses for You" Gamble

With this expectation that "the government will always step in to rescue us," moral hazard emerges.

• If they win: The bank reaps massive profits from high-risk investments, executives receive exorbitant bonuses, and shareholders make a fortune.
• If they lose: The bank incurs colossal losses and faces bankruptcy. At this point, to prevent the entire economy from being dragged down, the government has no choice but to use taxpayer money to "bail out" the bank and fill its financial holes.

You see, this becomes a perfect game of "I take the profits, you bear the risks." Bank executives have an immense incentive to engage in high-risk gambles because the worst outcome (liquidation) is effectively eliminated by the government's "implicit guarantee." They enjoy all the benefits of risk-taking without having to bear the most severe consequences.

3. The Vicious Cycle of Bailouts

Every successful bailout sends a signal to the entire market: "See? They really will rescue us!" This further reinforces the moral hazard mindset among other financial institutions. Everyone starts to think, "As long as I grow big enough, I can also enjoy this 'get-out-of-jail-free card.'"

This leads to an ever-increasing risk appetite within the entire financial system, as everyone plays a game of hot potato, potentially brewing larger-scale crises.

In summary:

In the context of financial bailouts, "moral hazard" refers to the willingness of financial institutions to engage in more aggressive and risky speculative activities because they expect to be bailed out by the government (taxpayers) if things go wrong. This mechanism is a deep-seated reason for the recurring financial crises and one of the most vexing problems for global regulatory bodies.