What is Moral Hazard?


Moral hazard is when the risk/cost of an action is borne by someone other than the person doing the action. If a person receives all the benefit and none of the cost, they will engage in excessive risky behavior because they are not punished for failure.

General Example

Let’s say there are two people (person A and person B). Person A commits crimes but every time they commit a crime, person B is punished for it. Person A will thus commit more crimes because they are not being punished for their actions. Moral hazard has occurred. Whatever marginal benefit person A gets for committing the crime (money, objects, etc.) will for a longer period of time be larger than the marginal cost for part of the cost is borne by person B. In a previous post, I talked about how people will engage in a behavior as long as it benefits them more than it costs them. If the costs of an actions are reduced, then all else equal the action will occur more often.

Financial Example

Let’s consider a banker who has to decide whether or not to loan somebody money. The person has been deemed to have a high risk of default. As a result, the bank is leaning towards not giving the person the loan. The government comes along and guarantees the loan. As the chance of a government default is miniscule to none, the banker provides the loan. If the original borrower defaults, the government pays and the bank is still made better off for this experience. If that borrower pays their loan, then the bank is also made better off for this experience. There is upside but no downside. The bank will thus take larger risks because that risk is borne by the government. Moral hazard has occurred again.

Fee Structure

Rate Assets Under Management
1.44% Below $125,000
1.00% Between $125,000 and $750,000
.85% Between $750,000 and $1,250,000
.80% Between $1,250,000 and $1,750,000
.75% Between $1,750,000 and $2,500,000
.70% Between $2,500,000 and $3,250,000
.65% Between $3,250,000 and $4,250,000
.60% Above $4,250,000

A single rate is applied to the entire account. So a person with a $750,000.01 account pays less than a person with a $750,000 account. I will waive personal tax return fees for accounts over $1 million. For accounts that are above $5,250,000, we’ll need to discuss a custom rate.

As I’m writing these to help my readers, I would be very appreciative of any input in regards to what I should write next. If you want me to write about a particular topic, please contact me. Please contact me if you would like to submit a post to my blog.

If anything that I mentioned above interests you, please consider downloading my free e-book. The book contains my thoughts on investment management and some information that I think everyone should know. You can also download it below.

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Questions for the comments

Did my explanation make sense? Do you agree or disagree with what I said?

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