Economic Concept of Moral Hazard

Moral hazard is an economic concept that holds that entities should assume the greater proportion of any risk associated with their activities. The assumption underlying this argument is that entities will not exercise the necessary or desirable levels of prudence if they know that they are not bearing a significant risk (Milgrom and Roberts 167).

As an example, some American economists argue that the availability of federal deposit insurance in the United States has contributed to the increase in the failure rate for both thrift institutions and commercial banks in that country (Cyrnak 1). The contention of these economists is that, if entities were required to bear the risk of deposit loss, they would exercise greater care in the selection and monitoring their banking institutions, and one outcome of such action would be that only strong and prudent banking institutions would survive because they would be the only ones to gain the confidence of depositors.

While there is a theoretical attraction to this argument, it fails to recognize that deposit insurance had been a part of the banking environment in the United States for 50 years before the sudden rash of thrift institution and commercial bank failures began to occur. If such an undesirable outcome as bank failure were going to derive from the existence of deposit insurance, one would have anticipated such an occurrence long before the decade of the 1980s. The argument also

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ssary to preclude the development of adverse economic consequences stemming from the flow of funds from weak banks to stronger banks. Goodhart (101-102) argues further that will "aim to prevent, or if that fails, to recycle such flows, subject to such safeguards as it can achieve to limit moral hazard and to penalize inadequate or improper managerial behavior." Goodhart (102) contends that such action on the part of a central bank is required because of the "important distinction between banks and other financial intermediaries a in the characteristics of their asset portfolio, which, in turn, largely determines what kind of liability they can offer a ." Banks, according to Goodhart (102), offer fixed-value liability, while collective investment funds offer market-value liability. Goodhart (102), thus, accepts the role for central banking that is involved in two aspects of the mandate of the Federal Reserve System in the United States. The Federal Reserve System is to act as a lender of last resort. In this role, the Federal Reserve System is to be in a position to furnish additional funds to member banks during periods of financial crisis. The Federal Reserve System is expected to add vigor to bank supervision in the count
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