Wednesday, June 18, 2008

Moral Hazard in the Curriculum

An interesting concept in both economics and personal finance is moral hazard. The simple explanation of moral hazard is that if you reduce risk, you change behavior. This seems easy enough to understand. And the most relevant application in personal finance is in the area of insurance.

If you insure against loss, you create a different set of costs and benefits for various types of activities. This can be applied to auto insurance, homeowners insurance, life insurance and health insurance. If you know that the financial cost of certain activities will be borne by a third party, in part or in total, your assessment of various activities is likely to change. Specifically, it is logical to believe that, to some extent, you will take on more risk than you would if the total cost of loss would be yours.

In economics, moral hazard has larger implications. I first ran across the term and the concept in the 1980s after the bailout of Continental Illinois Bank. At one time, Continental was one of the nation's largest banks. However, it invested heavily in oil and natural gas loans originated by Penn Square Bank in Oklahoma. When oil and natural gas prices fell in the early 80s, many of the loans defaulted and Continental (among others) was left holding a lot of non-performing loans. When Continental became illiquid, it was bailed out by a consortium of federal regulators and agencies, largely because the fear was the collapse of so large an institution represented significant systemic risk, and the term "too-big-to-fail" came into the lexicon. But it also raised concerns about whether bail-outs of large financial institutions set a bad precedent - one that sent the message that it was okay to take on more risk because the government would not allow big financial institutions to fail. (An interesting book about the Penn Square situation and how it embroiled Continental and other large banks is the book Belly Up: The Collapse of the Penn Square Bank.

This article in The Washington Post talks about several studies of behavior that seem to reinforce the concept of moral hazard. Author Shankar Vedantam points out that increasing safety can actually increase risky behavior, even outside the financial aspects of our lives.

Ultimately, the lesson for students in either economics or personal finance is to realize that reducing the cost of failure, at whatever level, affects the choices we make. Whether we are talking about physical activity or financial activity, if we know someone else is footing the bill, or even if we just are aware that there's a precedent for a bail-out, our cost-benefit analysis is changed and our choices change, however marginally.

Finally, there's a good piece at the National Public Radio (NPR) site that connects the concept of moral hazard to the sub-prime issue. That's especially worth discussing as politicians curry our favor with promises of protection, bailouts, and other ways of limiting the downside to our choices. It's worth a look, and I hope you find this helpful in explaining moral hazard to your students.

I look forward to your comments.


Mike Fladlien said...

seat belts increase accidents...has anyone ever researched why increased safety changes behavior that is more risky? i think a person who feels safe will then try to maximize her utility but pushing the limits of her constraint...

Tim Schilling said...

Call it what you will. If you reduce the potential cost, and the benefit does not change, you still face a possible change in outcome.

For example, given a choice where my benefit is x and my cost y, I am likely to choose "yes" as long as x>y. If x< or =Y, marginal analysis says "no". However, if you reduce y by some amount, you've increased the number of circumstances under which x>y. Which is what I think you're saying.

Mike Fladlien said...

your point is well taken...if x is the pleasure i get from driving and y is all costs, then as long as x>y won't i drive more and increase my risks?