Fictionary - Moral Hazard

By Devanshi Jain                                                                                                                     2 min read

Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both the parties have incomplete information about each other.

In a financial market, there is a risk that the borrower might engage in activities that are undesirable from the lender's point of view because they make him less likely to pay back a loan.

It occurs when the borrower knows that someone else will pay for the mistake he makes. This in turn gives him the incentive to act in a riskier way. This economic concept is known as moral hazard.

Typically, when in stress, banks around the world have been bailed out, ie, external funds (mostly taxpayer) have been used to rescue depositors and bond-holders. A bail-in is just the opposite, where depositor/bond-holder funds could be used to rescue a distressed bank. This leads to a situation of moral hazard for the customers.

In case of Yes Bank, The RBI had to act on an emergency basis before 14 March. Apart from fixing the share price to Rs 10, the RBI also said that all those who invested in the bank’s 81 additional tier 1 capital bonds — which pay back a higher rate of interest — will have no value. It did not do this earlier because if a buyer had come in earlier to buy the shares, the Securities and Exchange Board of India (SEBI) rules on having to make an open offer would have applied.