Support for bad banks also raises the specter of what economists call moral hazard. If bankers know that the central bank will lend cheaply when liquidity runs dry, they needn’t take care to avoid crises in the first place. In 1873, The Economist’s editor-inchief Walter Bagehot described the danger this way:
If the banks are bad, they will certainly continue bad and will probably become worse if the Government sustains and encourages them. The cardinal maxim is, that any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.
Mastering ‘Metrics – Angrist and Pischke
Moral hazard was first used in the insurance industry, but can also be observed in many other situations. The term refers to the negative behavior of an individual or a group being insured. When an entity is insured, they may take greater risks compared to when they were not secured by the insurance and may expose themselves to greater risks. Paul Krugman defines the term as: “any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.”
The examples are abundant. For instance, individuals who take some insurance for their car may drive more carelessly than ever before since someone else, here the insurance company, is bearing the risks. Likewise, an employee who feels that his or her position is safe in the firm may work with less efficiency. Also, banks may take greater risks if the government promises to support the loss-making banks.