Moral Hazard
A situation where one party takes on excessive risk because they do not bear the full consequences of their actions.
What is Moral Hazard?
Moral hazard is an economic concept describing how a party, insulated from the full consequences of their risky behavior, takes on more risk than they would otherwise accept. The term originated in the insurance industry: a person with comprehensive fire insurance may take fewer fire-prevention precautions than an uninsured person. In finance and economics, moral hazard arises when banks or financial institutions take excessive risks knowing that governments or central banks will bail them out if they fail ('too big to fail'). It also arises in principal-agent relationships — such as between shareholders and hired managers — where agents may act in self-interest at shareholders' expense.
Example
During the 2008 financial crisis, major banks had taken on enormous mortgage-backed security exposures with the implicit understanding that the government would not allow systemically important institutions to fail. When the government did bail out institutions like AIG and Bear Stearns (but not Lehman Brothers), critics argued this confirmed moral hazard — reinforcing expectations of future rescues and potentially encouraging future risk-taking.