Suppose Latasha comes into a large sum of money and decides to lend it out to earn interest on it. She realizes, however, that e
ven if she could evaluate whether a borrower is creditworthy before making a loan, she cannot ensure that her borrower will use the money as promised. She therefore deposits her money in a local bank, a financial intermediary. Because financial intermediaries can track customers' uses of money more easily than Latasha can and take action quickly in cases where borrowers use the money irresponsibly, this is an example of how financial intermediaries can help solve the problem of:
Banks reduce the risk of moral hazard when they monitor and supervise how their clients are using the loans and credits made to them.
Some types of credits do not require any type of monitoring or control, e.g. a credit card which a client can use basically however he/she wants to. But other types of credit that are taken for purchasing assets, e.g. a mortgage, must be used by the bank's client to specifically carryout the intended activity.
In economics, moral hazard refers to the tendency that an economic party can engage in unusually risky activities because the capital (money) that they are investing is not theirs and the negative effects of a potential loss will be suffered most by other parties.
