11 Moral Hazard: Banking and Student Loan Forgiveness

When someone enters into a transaction voluntarily, they accept the risks.  Buy a used car that breaks down on the way home.  You knew the risk, now you have to pay.  That is why we gather the necessary information before making a decision, so that we make one that reduces the risk of failure.  However, what happens to our behavior if that risk can be transferred?   For example, on a cold Minnesota day when you need to jump into the gas station to make a quick purchase do you leave the motor running and car unlocked?  It depends if you have all the risk or if the insurance company shoulders the loss should the car get stolen.  Insurance tends to change our behavior to more risk taking.   We call this moral hazard.  Moral hazard happens when there is no incentive to decrease risk taking because someone else promises to be responsible.  Moral hazard happens after a transaction.  For example, a person receives health insurance and now decides to take up skydiving.

Moral hazard can also be seen on a larger scale.  There have been several times in which the U.S. government has stepped in to prevent banking or industry failure.  For example, when the financial crisis in 2007 threatened to bring down several of the largest banks in the country the congress stepped in with the Troubled Asset Relief Program (TARP).  Under TARP the congress allocated $700 Billion to purchase toxic mortgage backed assets directly from the banks to help them recover(CRS 2020).  Many have argued by the government bailing out the banks, who held the risky assets in the first place, the behavior that caused the problem will only be encouraged.

Some in congress have advocated for student relief plans that would help pay outstanding balances for those that took out student loans.  Should a wide reaching plan come to fruition, how would such a policy impact student’s willingness to take out loans in the future?  Would this be the intention of the policy to increase riskier behavior?

Questions:

1. Define Moral Hazard in your own words. Provide an example of a time you encountered moral hazard in you own life.
2. Do some research and describe three times the government has stepped in to save an industry with a bailout.
3. Do some research and describe three ways insurance companies can mitigate moral hazard.
4. Do some research on the latest student loan relief proposal. Setting aside your specific situation, in your opinion is this a good policy for society?  Explain your reasoning.

References:

“Federal Assistance to Troubled Industries:  Selected Examples” (2020) Congressional Research Service

Schermele, Zachary. (2023) “Biden’s student loan relief plan would help borrowers with old loans, ballooning Interest” USA Today.  https://www.usatoday.com/story/news/education/2023/12/04/student-loan-forgiveness-proposal-biden-plan-b/71804017007/