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The term moral hazard has been thrown about by politicians and the press relating to the recent financial crisis. For some users of the term, it’s undoubtedly their first. I suspect from listening that many don’t really understand it.

Moral hazard is a technical term from the field of insurance and risk management. In essence, what it means is that “the ability to insure against a risky outcome changes your behavior with respect to that risk.” An absurd example is to say “I have life insurance so I can go sky diving” however you might likely find sound thinking people who refrain from skydiving because they don’t have life insurance. Other simple everyday examples might be found in neglecting to lock your car because it’s insured.

In the context of bailouts, the issue at debate is “if the Federal government bails out these institutions, don’t other institutions assume they’ll get bailed out also and thus embark upon riskier behavior.” Risky behavior for a bank is to make bad loans. So Congress and officials that oppose a bailout suggest that a Federal bailout will induce future participants to behave in riskier ways, assuming that they may be deemed “too big to fail.” For years Freddie and Fannie issued very high risk securities based upon a widely held assumption that the Federal government would ultimately back this paper, even though that was not legally the case.

In an effort to prevent these companies from feeling entitled to a Federal bailout, the Fed and Treasury let Lehman Brothers fail. Part of their logic was that unlike peer banks, Lehman had not begun to clean up its problems, so they should become an example. The financial market terror gripping world markets in the wake of Lehman’s failure is part of the very tough love shown by Federal officials. Part of the logic for regulators taking massive equity stakes during bailouts is to dampen the moral hazard effect. Original shareholders, while not scalped, have gotten close cropped haircuts for deals done so quickly.

It’s important to realize how much moral hazard has contributed to the weakness of our banking system in the first place. The existence of FDIC insurance introduces huge risk in the following way. If my deposit account is insured so long as I deposit in an FDIC bank, then as a consumer, I am indifferent to where my deposit goes. Banks, wishing to earn fat profits, have tremendous incentives to take more risk in their lending portfolios (higher risk, higher reward, so the saying goes). So they charge higher interest rates to less worthy borrowers (witness credit card rates) in hopes of making a killing. For them, it’s like going to the plate with 1000 strikes to use up. Swing for the fence every time.

The existence of FDIC insurance allows any bank, making any type of horrid loan, to attract deposits. If, by contrast, deposits were not insured, savers would be very careful to put their funds in only the strongest banks. Thus strong banks would have greater access to deposits, and their strong lending policies would prevail more fully in the market. Weaker banks with more aggressive lending portfolios might find it hard to attract depositor funds. In reality, consumers should worry if their bank offers high savings interest rates, as this is an indication of a riskier bank.

The FDIC does, however, serve to slow down bank runs during a panic. In the present environment, it probably makes sense to increase deposit insurance limits. The bad lending has already happened. Over the long run, though, the very existence of the insurance, and the moral hazard introduced to banking behavior, has largely gotten us into this problem.

Look for a future post on “partial regulation.” It’s hardly ever “de-regulation” that creates wild imbalances in financial markets, but partial regulation. In the case of our banking crisis, deposits have been regulated (insured) while lending has been unregulated, allowing slugger CEOs to swing away at every pitch to earn A-Rod sized bonues.