<p><a href="https://en.wikipedia.org/wiki/Moral_hazard" rel="nofollow noreferrer">Wikipedia</a>:  </p>

<blockquote>
  <p>In economics, moral hazard occurs when someone increases their exposure to risk when insured.</p>
</blockquote>

<p><a href="https://www.investopedia.com/ask/answers/09/moral-hazard.asp" rel="nofollow noreferrer">Investopedia</a>:  </p>

<blockquote>
  <p>Moral hazard is idea that a party protected in some way from risk will act differently than if they didn't have that protection. We encounter moral hazard every day—tenured professors becoming indifferent lecturers, people with theft insurance being less vigilant about where they park, salaried salespeople taking long breaks, and so on.</p>
</blockquote>

<p><a href="https://www.economicshelp.org/blog/105/economics/what-is-moral-hazard/" rel="nofollow noreferrer">Economics Help</a>:  </p>

<blockquote>
  <p>Moral Hazard is the concept that individuals have incentives to alter their behaviour when their risk or bad-decision making is borne by others.</p>
</blockquote>

<p>A moral hazard occurs when acting causes the behavior against which you are acting to increase.  </p>

<p>For example, bailing out a bank due to risky loans that the bank took encourages future banks to make riskier loans.  If the loans pan out, they make a lot of money.  If the loans fail, they get a bailout.  A bailout is less harmful than a bankruptcy, so they view it as less of a risk.  The bailout avoids a bankruptcy today, but it puts more companies at risk of bankruptcy tomorrow.  </p>

<p>In your example, you have two equally risky companies (or types of companies).  But the regulations regard one as riskier than the other.  So they encourage investment in one investment over the other.  That's the intended goal of the policy.  It's not a moral hazard if it is encouraging the intended behavior.  </p>

<p>Now, it may be that the policy is misguided and distorts the market in ways that are not intended.  But that is not a moral hazard.  It would only be a moral hazard if the rule were intended to encourage increased investment in A but due to the way it changed the incentives, it actually increased investment in B.  </p>

CC BY-SA 4.0
2018-06-23T07:37:51.627Z
I don't think this is the definition of moral hazard at all. Could you please back it up with a source?
Giskard
CC BY-SA 4.0
2018-06-24T06:44:28.013Z
This is still misleading: "moral hazard occurs when acting causes the behavior against which you are acting to increase.", and is not consistent with the referenced sources
410 gone
CC BY-SA 4.0
2018-06-23T00:09:55.980Z
2018-06-23T10:59:51.960Z
2018-06-23T10:59:51.960Z
Brythan
<p>"moral hazard" is probably not a good word to describe this, although it clearly can be related. </p>

<p>"moral hazard" (in this context) is when the bank makes riskier-than-optimal loans under the assumption that someone else will pick up the tab if a black swan event occurs. Or, more generally, something which systematically reinforces incentives to place costs (or risk) on a third party, while enabling the investor(s) to retain the full benefit with inadequate or no insurance. The result is then a "too-risky" loan portfolio relative to the optimum.</p>

<p>While the bank may indeed make calculated decisions in this context to make loans on the basis of some financial instrument or asset (e.g., loan) satisfying criteria to qualify as a specific form of capital when the underlying quality is in fact lower, that is not what would make it moral hazard. </p>

<p>What would make it moral hazard is if the bank were specifically calculating on the basis of known classification issues which would enable them to earn some flows of income which are 'too high' due to the ability to place cost or risk on the regulator or taxpayer. For example, without having to pay for insurance, or underpaying for insurance.  </p>

<p>I.e., even if done in a manner 100% consistent with the letter of the regulations, it is not the fact of some classification issue which enables to classify some volume of in-fact-low(er)-quality loans as high(er) quality loans to satisfy some regulatory requirement that makes it "moral hazard". But, rather, what makes it "moral hazard" is the <strong>incentive</strong> to place cost or risk on third parties who obtain 'insufficient' or no exposure to the upside.</p>

CC BY-SA 4.0
2018-06-23T15:51:04.697Z
2018-06-23T15:51:04.697Z
nathanwww
<blockquote>
  <p>Is this behavior by the bank (the agent) with respect to the regulator
  (the principal) a sort of moral hazard, taking into account that the
  actual riskiness of the companies is known by the bank but not by the
  regulator?</p>
</blockquote>

<p>No, it is not moral hazard. And I would add that it is not morally/economically wrong either.</p>

<p>The bank's decision to lend money to option B might be driven from B's expected return being higher than A's, which could be symptomatic of A's lack of competitiveness. The bank does not have a duty to insure or subsidize A. </p>

<p>Nor is the bank's duty to accommodate the regulator's inaccurate assessment of risks. In fact, if for whatever reason the bank accommodated the regulator's misconception despite [bank's] knowledge that <em>risk(A) = risk(B)</em> and <em>expected_return(A) &lt;= expected_return(B)</em>, funding A could contribute to creating a credit crunch in the sense that those resources could have been lent to other options that are more deserving (be it in terms of lower risk or of higher return at the same risk) of that loan.</p>

CC BY-SA 4.0
2018-06-23T22:45:04.867Z
2018-06-23T22:45:04.867Z
Iñaki Viggers
<p>The main shortcoming of the first Basel Accord (Basel I) was that its capital requirements did not reflect the actual risk of the bank assets.</p>

<p>One way this nonsense influenced the asset choice of banks was: risk being equal, they chose to reduce the availability of credit to some categories of borrowers shifting towards other categories with lower capital charge, at the expense of more socially preferable investments.</p>

<p>Now, suppose a bank has to choose between granting a loan to Company A and another investment, B, both equally risky.</p>

<p>Suppose that, due to the regulation rules, the bank has to put aside 150\$ of capital if it grants the loan to A or 100\$ if it invests in B. Hence, it will invest in B.</p>

<p>The same reasoning is valid for all the A-like companies and B-like investments, therefore it creates a credit crunch towards the former.</p>

<p>According to <a href="https://dictionary.cambridge.org/dictionary/english/credit-crunch" rel="nofollow noreferrer">https://dictionary.cambridge.org/dictionary/english/credit-crunch</a>, credit crunch is defined as:</p>

<blockquote>
  <p>economic conditions that make financial
  organizations less willing to lend money,
  often causing serious economic problems</p>
</blockquote>

<p>and this is bad for the regulator (which is the Central Bank or a similar State Agency).</p>

<p>Is this behavior by the bank (the agent) with respect to the regulator (the principal) a sort of moral hazard, taking into account that the actual riskiness of the companies is known by the bank but not by the regulator?</p>

CC BY-SA 4.0
2018-06-20T04:51:02.167Z
In what way does B not getting a loan incur costs for the regulator?
410 gone
CC BY-SA 4.0
2018-06-20T04:55:18.703Z
@EnergyNumbers The credit crunch is the cost, broadly. The regulator is the central bank and it should promote a correct credit allocation.
CarLaTeX
CC BY-SA 4.0
2018-06-20T05:45:26.980Z
A credit crunch is when lots of credit is withdrawn. You seem to be talking about something different: an absence of credit being granted, and I don't see how that creates a cost to the regulator. By the way, the regulator is not necessarily the Central Bank. Perhaps you mean the state is the principal? And it's unclear in your question as to the measure by which "both companies are equally risky" yet one merits higher capital requirements than the other.
410 gone
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2018-06-20T05:51:24.923Z
Wheres the cherry-picking?
Mozibur Ullah
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2018-06-20T07:01:33.617Z
@EnergyNumbers Your comments seem to thoroughly answer this question. Combine and post them as an answer?
Giskard
CC BY-SA 4.0
2018-06-21T05:23:55.377Z
@EnergyNumbers I edited my question trying to explain it better. I'm not a native English speaker, but according to what is said here: https://dictionary.cambridge.org/dictionary/english/credit-crunch, credit crunch is exactly what I mean.
CarLaTeX
CC BY-SA 4.0
2018-06-21T05:33:24.330Z
@EnergyNumbers Moreover, even if the regulator is not a Central Bank, it surely doesn't want to promote a credit reduction...
CarLaTeX
CC BY-SA 4.0
2018-06-21T05:34:12.897Z
@MoziburUllah I edited my question, I hope it's clearer now.
CarLaTeX
CC BY-SA 4.0
2018-06-23T22:18:11.680Z
@EnergyNumbers The issue that "*both companies are equally risky yet one merits higher capital requirements than the other*" may be determined by (1) the option giving the higher return, or (2) if both options offer the same return, by the bank's intent to reduce its exposure. In the latter case, the bank would decide for investment B and allocate the remaining capital (subject to Basel) to options that either are more profitable or safer.
Iñaki Viggers
<game-theory>
Is choosing an investment by a bank only due to its regulatory capital charge a form of moral hazard?
CarLaTeX
# Is choosing an investment by a bank only due to its regulatory capital charge a form of moral hazard?

(Asked by: username_0 on 2018-06-20)

The main shortcoming of the first Basel Accord (Basel I) was that its capital requirements did not reflect the actual risk of the bank assets.

One way this nonsense influenced the asset choice of banks was: risk being equal, they chose to reduce the availability of credit to some categories of borrowers shifting towards other categories with lower capital charge, at the expense of more socially preferable investments.

Now, suppose a bank has to choose between granting a loan to Company A and another investment, B, both equally risky.

Suppose that, due to the regulation rules, the bank has to put aside 150\$ of capital if it grants the loan to A or 100\$ if it invests in B. Hence, it will invest in B.

The same reasoning is valid for all the A-like companies and B-like investments, therefore it creates a credit crunch towards the former.

According to <https://dictionary.cambridge.org/dictionary/english/credit-crunch>, credit crunch is defined as:

> economic conditions that make financial
> organizations less willing to lend money,
> often causing serious economic problems

and this is bad for the regulator (which is the Central Bank or a similar State Agency).

Is this behavior by the bank (the agent) with respect to the regulator (the principal) a sort of moral hazard, taking into account that the actual riskiness of the companies is known by the bank but not by the regulator?

**Tags:** game-theory

> **Comments:**
> **username_1**: In what way does B not getting a loan incur costs for the regulator?  
> **username_0**: @EnergyNumbers The credit crunch is the cost, broadly. The regulator is the central bank and it should promote a correct credit allocation.  
> **username_1**: A credit crunch is when lots of credit is withdrawn. You seem to be talking about something different: an absence of credit being granted, and I don't see how that creates a cost to the regulator. By the way, the regulator is not necessarily the Central Bank. Perhaps you mean the state is the principal? And it's unclear in your question as to the measure by which "both companies are equally risky" yet one merits higher capital requirements than the other.  
> **username_2**: Wheres the cherry-picking?  
> **username_3**: @EnergyNumbers Your comments seem to thoroughly answer this question. Combine and post them as an answer?  
> **username_0**: @EnergyNumbers I edited my question trying to explain it better. I'm not a native English speaker, but according to what is said here: https://dictionary.cambridge.org/dictionary/english/credit-crunch, credit crunch is exactly what I mean.  
> **username_0**: @EnergyNumbers Moreover, even if the regulator is not a Central Bank, it surely doesn't want to promote a credit reduction...  
> **username_0**: @MoziburUllah I edited my question, I hope it's clearer now.  
> **username_4**: @EnergyNumbers The issue that "*both companies are equally risky yet one merits higher capital requirements than the other*" may be determined by (1) the option giving the higher return, or (2) if both options offer the same return, by the bank's intent to reduce its exposure. In the latter case, the bank would decide for investment B and allocate the remaining capital (subject to Basel) to options that either are more profitable or safer.  

---

## 3 answers

### Answer by username_5 on 2018-06-23. Score: 1 | Accepted answer

[Wikipedia](https://en.wikipedia.org/wiki/Moral_hazard):

> In economics, moral hazard occurs when someone increases their exposure to risk when insured.

[Investopedia](https://www.investopedia.com/ask/answers/09/moral-hazard.asp):

> Moral hazard is idea that a party protected in some way from risk will act differently than if they didn't have that protection. We encounter moral hazard every day—tenured professors becoming indifferent lecturers, people with theft insurance being less vigilant about where they park, salaried salespeople taking long breaks, and so on.

[Economics Help](https://www.economicshelp.org/blog/105/economics/what-is-moral-hazard/):

> Moral Hazard is the concept that individuals have incentives to alter their behaviour when their risk or bad-decision making is borne by others.

A moral hazard occurs when acting causes the behavior against which you are acting to increase.

For example, bailing out a bank due to risky loans that the bank took encourages future banks to make riskier loans. If the loans pan out, they make a lot of money. If the loans fail, they get a bailout. A bailout is less harmful than a bankruptcy, so they view it as less of a risk. The bailout avoids a bankruptcy today, but it puts more companies at risk of bankruptcy tomorrow.

In your example, you have two equally risky companies (or types of companies). But the regulations regard one as riskier than the other. So they encourage investment in one investment over the other. That's the intended goal of the policy. It's not a moral hazard if it is encouraging the intended behavior.

Now, it may be that the policy is misguided and distorts the market in ways that are not intended. But that is not a moral hazard. It would only be a moral hazard if the rule were intended to encourage increased investment in A but due to the way it changed the incentives, it actually increased investment in B.

> **Comments:**
> **username_3**: I don't think this is the definition of moral hazard at all. Could you please back it up with a source?  
> **username_1**: This is still misleading: "moral hazard occurs when acting causes the behavior against which you are acting to increase.", and is not consistent with the referenced sources  

---

### Answer by username_6 on 2018-06-23. Score: 1

"moral hazard" is probably not a good word to describe this, although it clearly can be related.

"moral hazard" (in this context) is when the bank makes riskier-than-optimal loans under the assumption that someone else will pick up the tab if a black swan event occurs. Or, more generally, something which systematically reinforces incentives to place costs (or risk) on a third party, while enabling the investor(s) to retain the full benefit with inadequate or no insurance. The result is then a "too-risky" loan portfolio relative to the optimum.

While the bank may indeed make calculated decisions in this context to make loans on the basis of some financial instrument or asset (e.g., loan) satisfying criteria to qualify as a specific form of capital when the underlying quality is in fact lower, that is not what would make it moral hazard.

What would make it moral hazard is if the bank were specifically calculating on the basis of known classification issues which would enable them to earn some flows of income which are 'too high' due to the ability to place cost or risk on the regulator or taxpayer. For example, without having to pay for insurance, or underpaying for insurance.

I.e., even if done in a manner 100% consistent with the letter of the regulations, it is not the fact of some classification issue which enables to classify some volume of in-fact-low(er)-quality loans as high(er) quality loans to satisfy some regulatory requirement that makes it "moral hazard". But, rather, what makes it "moral hazard" is the **incentive** to place cost or risk on third parties who obtain 'insufficient' or no exposure to the upside.


---

### Answer by username_4 on 2018-06-23. Score: 1

> Is this behavior by the bank (the agent) with respect to the regulator
> (the principal) a sort of moral hazard, taking into account that the
> actual riskiness of the companies is known by the bank but not by the
> regulator?

No, it is not moral hazard. And I would add that it is not morally/economically wrong either.

The bank's decision to lend money to option B might be driven from B's expected return being higher than A's, which could be symptomatic of A's lack of competitiveness. The bank does not have a duty to insure or subsidize A.

Nor is the bank's duty to accommodate the regulator's inaccurate assessment of risks. In fact, if for whatever reason the bank accommodated the regulator's misconception despite [bank's] knowledge that *risk(A) = risk(B)* and *expected\_return(A) <= expected\_return(B)*, funding A could contribute to creating a credit crunch in the sense that those resources could have been lent to other options that are more deserving (be it in terms of lower risk or of higher return at the same risk) of that loan.


---

