Moral hazard is defined as the risk that a party has not entered into a contract in good faith or has provided misleading information about its assets, credit capacity, or liabilities.
Moral hazard is a problem that appears in financial markets as a consequence of the presence of asymmetric information, which is when one party does not know enough about the other party to make accurate decisions.
This inequality tends to appear for example when a borrower who decides to take out a loan has better information about the potential return and risks associated with the investment projects for which the funds are intended than the lender does.
Moral hazard is the problem that occurs when borrowers have information that lenders do not have, and is created by asymmetric information after the transaction occurs.
It is created by the fact that potential borrowers might engage in activities that are undesirable from the point of view of the lender because they make it less likely that the loan will be paid back, which will result in a loss for the lender.
To better understand this concept here is an example: suppose that your friend Mark asks you for a $700 loan because he needs to buy a new laptop for school. Once you have made the loan, however, Mark is more likely to slip off to the track and go betting on a football game where he expects to earn 10 times his bet. If he wins, he will be able to pay back the loan and to enjoy an extra $6,300 but if he loses (which is the most likely outcome), you won’t get paid back, and all he has lost is his reputation as a reliable friend.
Your friend Mark, therefore has an incentive to go betting on the football game, because if he bets correctly he will enjoy larger gains than the cost to him if he bets incorrectly (his reputation). If you knew what Mark was up to, you would prevent him to take that risk, and he would not be able to increase the moral hazard, but however, because of asymmetry of information, there is a good chance that he will decide to bet and that you will not get paid back.
This same mechanism does not happen just in these simple forms but also in larger and more complex organizations, where firms and even governments are involved.
The role of financial intermediaries
Fortunately, financial intermediaries can alleviate the problems created by moral hazard, in fact, thanks to their presence in the economy, even small savers can provide their money to financial markets by lending their excess funds to a trustworthy intermediary, which will lend them out either by making loans or by buying securities (e.g. bonds or stocks).
Financial intermediaries can help a lot to mitigate the effects of moral hazard in the market because they are better equipped and have developed greater expertise in monitoring the parties they lend to. This means that intermediaries can increase their returns on their investments and therefore they can also afford to pay savers interest.
This is one of the reasons why, without a well-functioning set of financial intermediaries, it is very hard for an economy to reach its full potential.