What is moral hazard
Moral hazard is the tendency to take more risk when someone else will bear most of the cost if things go wrong.
The person taking the risk keeps the upside but passes the downside to an insurer, a lender, a client, depositors or the government. Because they are protected, their behaviour changes after the arrangement is in place.
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A worked example
This is a hypothetical case.
Ali manages trading capital for his cousin. The deal is that Ali takes a share of any profit, and the cousin absorbs every loss. Ali's own money is not at risk.
- If Ali opens a large, leveraged position and it wins, he earns his share of a big profit.
- If the same position loses, the whole loss falls on the cousin.
Ali now has a reason to choose bigger and riskier positions than he would with his own money. Nothing in the deal punishes him for a loss. That gap between who decides and who pays is moral hazard.
The cost here is real. Leveraged CFD and forex positions can lose money fast, and a loss can wipe out an account before anyone reacts. See Risk management for how position size and stop-losses limit that.
Formal definition
In economics, moral hazard is a principal–agent problem with hidden action. A principal (the insurer, lender or investor) cannot fully observe what the agent does after a contract is signed. The agent's payoff does not fully reflect the cost of their actions, so they act in ways that raise the principal's expected loss.
It is often confused with adverse selection:
| Term | When the problem arises | What is hidden |
|---|---|---|
| Moral hazard | After the contract | The agent's actions or effort |
| Adverse selection | Before the contract | The agent's type or true risk |
Moral hazard in finance: where you see the term
- Bank bailouts and "too big to fail". News and central bank reports use the term when large banks may take risk expecting public support. Bail-ins are partly designed to reduce it by making creditors share losses.
- Deposit insurance. It helps prevent a bank run, but it can weaken depositors' incentive to watch how their bank lends.
- Fund manager fees. A performance fee with no penalty for losses works like a free option on volatility.
- Lending with weak collateral. Borrowers with little of their own money at stake may take bigger bets, which raises default risk.
- Broker business models. Discussions of A-book and B-book execution touch on incentives when a firm is the counterparty to client trades.
Edge cases
- Not every protection creates moral hazard. If the protected party cannot change their behaviour, there is no hidden action and no moral hazard.
- Deductibles and co-payments in insurance, and "skin in the game" rules for managers, exist to reduce it by making the agent share part of the loss.
- Protection against negative balances in leveraged trading limits a client's loss to the account balance. Some argue this weakens the incentive to size positions carefully. The protection does not remove the risk of losing the deposit.
Related terms
Bail-in · Bank run · Fractional reserve banking · Financial contagion · Credit crunch · Credit spread · Fat tails and tail risk · Trading glossary
Frequent questions
What does moral hazard mean in simple words?
It means someone takes bigger risks because another party will pay if the risk goes wrong.
What are common moral hazard examples?
Common examples are bank bailouts, deposit insurance, insured drivers who take less care, and managers paid on profits but not penalised for losses.
Is moral hazard the same as adverse selection?
No. Adverse selection is about hidden information before a deal. Moral hazard is about hidden behaviour after the deal.
How do institutions reduce moral hazard?
They make the risk-taker share losses through deductibles, collateral, bail-in rules, capital requirements and pay tied to long-term results.