Moral Hazard in the Banking Sector

Moral hazard occurs in banking, affecting many parties.

A major function of a commercial bank is to work as an intermediary between depositors and borrowers.

Depositors include parties such as individuals who deposit their money in the bank. Borrowers include parties such as companies that take loans from the bank.

For example, a car manufacturing company takes a loan to increase production. 

The loan amount is expected to be used for activities including increasing the physical space of production facilities, upgrading machinery, and investing in automation.

However, the company uses a large amount of the loan for nonproductive purposes such as office furnishing, unnecessary travel expenses, and company events. 

This could result in the company generating inadequate cash flow to repay the debt and default on the loan.

Such irresponsible behavior increases risks to the bank. 

The depositors may also suffer as they may not be able to retrieve their funds fully or may experience delays in accessing their money.

If many loans are not paid back, the government may need to bail out the bank, which affects the country’s taxpayers.