Moral Hazard: Definition, History, Ways to Overcome, and Impact

Moral hazard is an action that often occurs in a company. The initial use of
the term itself had a negative connotation, implying fraud
or immoral behavior.

A number of bankers then proposed that the credit restructuring period affected by Covid-19 could be
extended again for at least one year.
The current economic pressures have left concerns for
the debtor’s performance prospects.

Until now, the Financial Services Authority (OJK) is currently studying this possibility. In
fact, a number of observers have also asked banks to be aware of the potential moral hazard from debtors if
the credit restructuring period affected by Covid-19 is extended again.

What is meant by moral hazard? What are the causes and effects of moral hazard?
How to overcome and prevent moral hazard? You can find all these questions in this
article, Sinaumed’s.

Definition of Moral Hazard

Moral hazard is a risk that a party has not signed a contract in good faith or has provided misleading
information regarding assets, liabilities or regarding their credit capacity.
Kotowitz in
The New Palgrave Dictionary of Economics then states that moral hazard is the
action of agents in maximizing their utility by previously sacrificing others and in situations where they
do not bear all the consequences or do not fully enjoy the benefits of these actions.

Moral hazard itself is often used in terms of the insurance business. Moral hazard is the
possibility that the insurer deliberately takes actions that can harm the insured goods in the hope of
getting a replacement claim from the insurance company.
The word moral hazard itself is then
often used in a banking perspective which refers to the behavior of interested parties
(stakeholders) .

Paul Krugman himself stated that the concept of moral hazard has been widely used in explaining various behaviors
of debtors (borrowers) and lenders (creditors/banks) who dared to take high risks during the financial
crisis that occurred in Southeast Asia in 1997-1998.

Luiz A. Pereira, Silva & Masaru Yoshitomi stated that moral hazard is a behavior of interested parties
(stakeholders) , for example the bank (shareholders and management) or banking debtors which then creates
incentives to have hidden agendas and actions that are contrary to business ethics and laws that apply to
his advantage.

These interested parties are on behalf of the corporation, or for the benefit of the corporation, based on a work
relationship or based on other relationships, within the scope of corporate business, either individually or

History of Moral Hazards

The term moral hazard itself originated in the 17th century and was widely used by British insurance
companies in the late 19th century by Dembe and Boden.
The concept of moral hazard was the
subject of new research by economists in the 1960s and later implied immoral or fraudulent behavior.

Economists use the term moral hazard to describe the inefficiencies that can occur when risks are
transferred or cannot be fully evaluated, rather than descriptions of the ethics or morals of the parties
Until now, moral hazard is often identified with a behavior in the form of fraud
committed by individuals or groups.
The fraud tends to lead to the economic sector, such as
insurance, banking, and the like.

How to Overcome Moral Hazard

Basically, moral hazard can be overcome. The following are ways to overcome moral hazard cited
from various sources:

Build Motivation or Incentives

This can be seen in insurance, to avoid moral hazard, insurance companies will design contracts to provide
incentives for customers to insure a product.
They also will not insure the full amount, where
there is also a process for paying the first down payment of an insurance claim.
companies will also complicate the process of obtaining money, so insurance users will be more reluctant to
file claims.

Punishing Bad Behavior

The government can then provide bank guarantees and punish those responsible for making reckless decisions,
such as in performance-paying decisions on the part of individuals.
That means, in order to
avoid moral hazard in the labor market, some form of performance evaluation is carried out and there is no
guarantee of lifetime employment.

In simple terms, giving punishment to those who intend to commit moral hazard. That way, moral
hazard actions can be handled optimally.

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Preventing Moral Hazard in Banking

Taswin Ibrahim and Ragimun in a journal entitled Moral Hazard and its Prevention in the Banking Industry in
Indonesia then wrote about efforts to prevent moral hazard, namely

  1. Strengthening the regulation on the implementation of risk-based guarantee premiums.
  2. There needs to be restrictions on bank ownership.
  3. Discipline levy so that the market can be carried out through transparency of information and reduction of
    deposit guarantee values.
  4. Implementation of risk-based management or supervision.

The application of risk management in banking itself needs to comply with the principles of:

1. Transparency, or a
Risk Management Policy that Must Be Transparent

By doing so, all potential risks must be disclosed openly. This hidden risk will then become a
source of big problems in the future.

2. Appropriate Assessment

The point is that it must be based on an accurate assessment methodology. The
company then needs to make continuous investments to be able to develop various concepts, methodologies, and
tools and techniques continuously to then build strong risk management.

3. Quality and timely information

This needs to be done because it will support assessment accuracy and quality measurements for decision making.

4. Diversification

By doing this, the dangerous risk for the bank can be overcome.

5. Independence

The point is that risk management must be based on independence in a relationship between each unit in the

6. Disciplined Decision Patterns

The point is that no matter how good the concepts, methodologies and tools and techniques are used, the
quality of decisions at risk depends on how management decides the best way to use the available concepts,
methodologies, tools and techniques.
Therefore, the decision-making process must then refer to
a standard pattern followed by high discipline.

7. Determination of Banking Risk Limits and

Setting limits will then provide maximum certainty in taking risks and narrowing down opportunities to commit
moral hazard.

8. Implementation of Internal Control on
Every Transaction

With proper control of each transaction, moral hazard can be prevented.

Moral Hazard Causes and Impact

Moral hazard in banking can occur due to weaknesses in regulations and legislation, ownership structure factors,
aspects of deposit insurance and credit lending aspects, as well as weakened market discipline.

Therefore, good and stable regulations should be found or created, be able to regulate properly, not lead to a
concentration of economic power, then have the flexibility to grow the banking industry, and have the ability to
distinguish which banks are healthy and which are not.

The following below are the factors that cause moral hazard:

  1. Low income: It is believed that the reason why individuals will later participate in moral hazard is due to
    lack of income or sufficient resources to control future costs.
  2. Lack of personal or moral values
  3. Lack of personal values ​​that uphold honesty is sometimes a factor that encourages someone to do moral
  4. Information discrepancies between principals and agents which then lead to what is commonly referred to as a
    conflict of interest where each party then tries its best to maximize the benefits of the other.

Impact of Moral Hazard

Moral hazard also refers to a situation that then arises when an individual has the opportunity to take
advantage of various financial agreements or situations, knowing that all risks and impacts will then fall
on other parties.
This means that one party is open to options – and therefore tempted – to
take advantage of the other party.

The second party itself as the party that bears all the consequences of every risk that is then taken in a
moral hazard situation, allows the first party to be free to do whatever they want, without fear of
They are able to ignore all moral implications and act in the way that is most
beneficial to them.
The impact of moral hazard includes:

1. Cost overruns

Expense overruns that are not in accordance with the budget Individuals who bear the burden of risk will spend
more than budgeted for the same risk due to moral hazard.

2. Conflicts of Interest and Legal Cases

Moral hazard also results in conflicts of interest and legal cases when both parties later become aware of
various missing information.

3. Triggering Corruption

One of the main impacts of moral hazard is corruption. Individuals who are willing to maximize
their profits from activities that don’t cost a penny.

Moral Hazards and Their
Prevention in the Banking Industry in Indonesia

The banking industry is a unique industry when compared to other industries. In this case,
other industries, such as profit-oriented industries, this industry also carries out its supervisory role or
monitors debtors, on the other hand this industry is also monitored by depositors, including regulators and
deposit insurance agencies. .

Depositors do not directly monitor the use of funds which are then placed with debtors, but banking
institutions that monitor debtors have a role as a mandate for depositors or depositors of funds at the
This monitoring or control will work properly when they have aligned interests.

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If there is no alignment of incentives and interests between them, a conflict of interest will occur.
In fact, it will complicate various monitoring functions, whereby shareholders can then take high
risks at the expense of other shareholders, depositors, and deposit insurance institutions.

Therefore, the role of regulation regarding moral hazard is managed properly and wisely. This
needs to be done because it really functions as a public representation related to monitoring in the banking

The case of the burglary of Citibank customer funds which was then carried out by certain individuals either on
their own behalf or on certain conspiracies is a clear example of moral hazard in the banking world in

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Moral hazard is an action that should not be taken because it can harm other people or can
even bankrupt a company.
Therefore, we do our best to prevent moral hazard from occurring, so
that criminal acts of corruption can be avoided.
This is a review of Moral Hazard, starting
from its definition, history, steps to overcome it, its causes and effects.
Hope it is

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