The moral hazard of limited liability

A predominant example of moral hazard is the application of limited liability to the shareholders of publicly listed private-sector corporations. This column argues that changing the incentives for senior employees and majority shareholders for listed firms may be the most effective form of regulation. The author suggests that creating a system where managerial staff and other shareholders are incentivised to adhere to best practice to protect themselves, as well as the firm in question, is optimal.

Moral hazard occurs when the ‘costs’ of a bad outcome of a (predictable) risk fall, in part or in whole, on someone other than those taking the risk, while at the same time benefiting from good outcomes. If the probabilities of that risk can be ascertained in advance, then, in principle, the risks can be insured and the risk taker will have to pay a higher premium, for example for obligatory flood insurance on a house built by a river. In this case, the moral hazard would then disappear.  Otherwise, moral hazard leads those subjected to it to take excessive risks.

While concern about such moral hazard has been widespread in macroeconomics, the application of this concept has been quite selective, usually focussed on occasions when the state has chosen to bail out persons and/or institutions that have fallen on hard times. What has been mostly missing from such discussions in recent decades has been the realisation that in capitalist macroeconomic systems, the predominant example of moral hazard has been the application of limited liability to the shareholders of publicly listed private-sector corporations.1 Thus, if such a company goes bankrupt, the costs involved do not fall fully on its owners, but are generally passed on to its other creditors. This naturally leads shareholders to pursue riskier and sub-optimal strategies.

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