The moral hazard problem arises when a party has a tendency to embrace more risk knowing that the cost of taking such a risk will not be borne by him. The knowledge that the cost of risk taking will be paid partly or wholly by others incentivizes risk taking. Moral hazard arises because individuals or organizations which are taking risks don’t take full consequences or responsibilities of its own actions. Moral hazard usually is case of information asymmetries. When there is information asymmetries, the risk taking individual/organization have more information compared to others.
Nobel Prize winner in Economics, Paul Krugman is known for his studies on Moral Hazard problem. According to him, moral hazard is “any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.”
During the global financial crisis, large number of bank failures has activated debate on moral hazard problem. When the government and central banks are providing financial bailouts of failed institutions, it may encourage excessive risk taking in the belief that they will not have to carry the full burden of potential losses. In many western countries financial conglomerates have developed a notion called too-big to fail.