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Moral Hazard

In financial economics, moral hazard refers to the tendency of individuals or institutions to take on more risk when they are insulated from the potential consequences of their actions. It arises when there is a disconnect between the risks and rewards of a decision or investment, leading to misaligned incentives and potentially harmful outcomes.

Moral hazard can occur when individuals or institutions believe that they will be bailed out or protected from losses, leading them to engage in riskier behaviour than they would if they bore the full cost of their decisions.

For example, a bank might take on excessive risk in its lending practices if it believes that it will be bailed out by the government in the event of a crisis.

Moral hazard can also arise in situations where the risks of a decision or investment are not fully understood or disclosed, leading to mis-pricing or misallocation of capital.

For example, complex financial instruments, such as derivatives or structured products, may create moral hazard by obscuring the underlying risks and making it difficult for investors to accurately assess their potential losses.

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