What the hell is moral hazard?

Andrew Pegler – 08 January 2010

Now that you have recovered from your annual Christmas dose of family enmity I want to chat to you about moral hazard. And, no, this is not a sermon on your behaviour over the break; it’s a finance term and it will be a big issue this year.

At the height of the GFC, after the Lehman Brothers collapse froze international credit and we were all going to hell in a handbasket, Australia, like many other countries, issued a federal government bank guarantee. What this meant was that Kev and Wayne promised that if your bank went belly up they would guarantee your deposit. In addition to that, any institution that lent money to an Aussie bank would be paid back by the Australian Government if all else failed. Both these guarantees ensured banks stayed in business and that the economy didn’t grind to a halt. Nice day’s work boys.

But there is a flipside and it’s called moral hazard.

Moral hazard refers to the idea that people who are insured take greater risks. (Kinda like that hire car you thrashed in Byron Bay last year.) In this case the people who now have insurance are the banks and by default all the super funds, financial institutions, hedge funds and just about every other corner of the financial system i.e. pretty much anywhere you have parked your hard-earned. The fear is that once things recover these guys may start to take more risks than they ought in the knowledge that if it goes pear shaped again the good ole federal government will bail ’em out.

Now I am not against the idea of a bank guarantee. We were all stuffed without it but it sends a bad message to the financial services and investing community. A message of moral hazard.

So this year as the whole GFC mess starts to recede keep your eyes on what people start to do with your hard-earned and be prepared to move it if you think they are getting a little careless. But right now it’s still very early January so kick back and continue hallucinating to the freestyle beats of your evaporative cooler.

And in other news… while on the subject of moral hazard Greece is currently a great example of how it can apply to a whole country. As I have written before, the Greek economy is currently up Ouzo creek without a souvlaki and it’s hoping the EU will bail it out. However, if the EU does come to the toga party, as it’s being pressured to do, what’s to stop Greek policy makers continuing to pursue bad policies in the knowledge they have fall-back if the wheels fall off again?

As always I welcome your feedback and any ideas for subjects I can tackle. So go on, let us know what’s on your mind – log in and post your comments below.