First define moral hazard and provide a specific example The

Solution

Moral hazard is the phenomenon when cost or the risk associated with the decision taken by one person is paid by the other person. Here, the decision makers consider themselves to be insured of the consequences of the decision if it goes wrong and other parties pay for the losses. It can be understood by the example of a bank lending people with doubtful credentials. Here, moral hazard happens, because bank manager issue the loan to those people who have poor credit ratings to bring business to the bank. It creates risk. Now, if loan is defaulted, then it is the depositors with their money and the shareholders of the bank, who suffer from the risk taken by the bank manager. Therefore, it is a case of moral hazard.
Government\'s role in this regard is to set the accountability of the managers, directors and CEOs and all other decision makers in the organization and take stringent measures so that these people don’t go for the moral hazard. Here, the government should empower the sta-tu-tory agencies to go for regular verification, ask for the disclosures and develop a risk management framework in the organization so that moral hazard problem as market failure is prevented.