Question

Students often have trouble distinguishing between adverse selection and moral hazard. Both concepts are rooted in asymmetric information among different parties in a transaction or contract. Both contribute to risk and these risks arise from a specific source – asymmetric information

In this week’s forum, I would like you to engage with each other to clarify your understanding of these concepts.

Discuss the prevalence of asymmetric information in insurance contracts, in lending, in investment…

Discuss adverse selection. Any examples.

Discuss moral hazard. Any examples?

How are the two different?

When you apply at a financial institution for a loan, you asked to fill out extensive loan applications, provide detailed financial information, provide loan collateral, etc. In addition, you may find that the money is dispensed to you as you meet certain performance criteria (example, as in a construction loan). Discuss how the loan approval and distribution process reduce risks to the financial institution associated with both adverse selection and moral hazard.

Answer 1

Moral Hazard	Adverse Selection
Occurs when there is asymmetric information between two parties and a change in the behavior of one party after a deal is struck.	Occurs when there's a lack of symmetric information prior to a deal between a buyer and a seller.
Occurs when one party has an incentive to behave differently once an agreement is made between parties	Occurs when one party in a transaction has better information than the other party
After transaction occurs	Before transaction occurs
Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back	Potential borrowers most likely to produce adverse outcome are ones most likely to seek loan and be selected
Post-contractual asymmetry	Pre-contractual asymmetry
Action is hidden	Information is hidden
Moral hazard occurs when insured consumers are likely to take greater risks, knowing that a claim will be paid for by their cover	Health insurance: those most likely to purchase health insurance are those who are most likely to use it, i.e. smokers/drinkers/those with underlying health issues
The consumer knows more about his/her intended actions than the producer (insurer)	Only high risk consumer knows the gain

Example 1: Drivers with air bags are more likely to get into traffic accidents.

In the above situation, the adverse selection explanation is that bad drivers are more likely to purchase cars with airbags. If you know you are likely to get into an accident, it makes sense to purchase a car with airbags. The moral hazard explanation is that once drivers have the protection of airbags, they take more risks and get into more accidents. If you don’t believe that people change behavior in this way run a simple experiment – next time you drive somewhere, do not wear a seat belt. See if you drive more carefully.

Example 2 : Volvo drivers are more likely to run stop signs.

In the above scenario, adverse selection – people who are more likely to run stop signs will want to buy safer cars, so they will be more likely to buy Volvos. Moral hazard – once you own a Volvo, you feel safer so you will be more likely to run a stop sign

Example 3 : At all-you-can-eat restaurants, customers eat more food.

In this, adverse selection – attracts people who are more likely to be big eaters.

Moral hazard – once you have paid for all you can eat, you are more likely to eat more.

Moral hazard occurs in different types of situations and different arenas. In the financial sector, one motivator can be bailouts. Lending institutions tend to make their highest returns on loans that are considered risky. They are more inclined to make such loans when they have the assurance or expectation of some sort of government aid in the event of loan defaults.

Mortgage securitization can lead to moral hazard – and did, in the subprime meltdown and financial crisis of 2008. Originators of mortgages can pool the loans, and then sell pieces of this mortgage pool to investors, thus passing the risk of default on to someone else. In such a situation, it benefits the buyer or buying agency to be diligent in monitoring the originators of the loans and in verifying loan quality.

For lending to individuals, lenders can check the loan applicant's credit files and credit scores, their employment history, and with the permission of the borrowers, lenders can even verify their income with the Internal Revenue Service.

Smaller firms, who are unable or unwilling to obtain financing through the issuance of stocks or bonds, apply for loans. Lenders can lower their risk of moral hazard lending to these small firms by using the standard debt contract, sometimes referred to as the optimal debt contract. Small firms often borrow money for specific projects, but it is difficult for lenders to determine the profitability of those projects. Additionally, costs would be incurred by investigating or monitoring the project. So, in addition to the traditional credit screening tools, the lender can stipulate via the contract that monitoring or vestigating the project will not be undertaken as long as the borrower repays its debt. If the repayment is insufficient, delayed, or nonexistent, then the lender must spend some money for monitoring or investigating, to identify sources of revenue, which the lender can attach or levy to fulfill the repayment of the loan.