1. What is moral hazard and what are its implications for purchasers of insurance?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. 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, 1986, pp. 1 3). 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 fails to recognize what kind of banking and financial environment the United States might have had since the mid 1930s, if consumer confidence in the system had not been
restored largely through the creation of federal deposit insurance. Nevertheless, critics of federal deposit insurance in the United States have scored some gains, as a consequence of the savings and loan crisis. Legislation has been enacted into law that...