Free Riding in Finance: A Primer

Many features of our financial system—institutions like banks and insurance companies, as well as the configuration of securities markets—are a consequence of legal conventions (the rules about property rights and taxes) and the costs associated with obtaining and verifying information. When we teach money and banking, three concepts are key to understanding the structure of finance: adverse selection, moral hazard, and free riding. The first two arise from asymmetric information, either before (adverse selection) or after (moral hazard) making a financial arrangement (see our earlier primers here and here).

This primer is about the third concept: free riding. Free riding is tied to the concept of a public good, so we start there. Then, we offer three examples where free riding plays a key role in the organization of finance: credit ratings; schemes like the Madoff scandal; and efforts to secure financial stability more broadly....

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Moral Hazard: A Primer

The term moral hazard originated in the insurance business. It was a reference to the need for insurers to assess the integrity of their customers. When modern economists got ahold of the term, the meaning changed. Instead of making judgments about a person’s character, the focus shifted to incentives. For example, a fire insurance policy might limit the motivation to install sprinklers while a generous automobile insurance policy might encourage reckless driving. Then there is Kenneth Arrow’s original example of moral hazard: health insurance fosters overtreatment by doctors. Employment arrangements suffer from moral hazard, too: will you shirk unpleasant tasks at work if you’re sure to receive your paycheck anyway?

Moral hazard arises when we cannot costlessly observe people’s actions and so cannot judge (without costly monitoring) whether a poor outcome reflects poor fortune or poor effort. Like its close relative, adverse selection, moral hazard arises because two parties to a transaction have different information. This information asymmetry manifests itself in two ways. Where adverse selection is about hidden attributes, affecting a transaction before it occurs, moral hazard is about hidden actions that have an impact after making an arrangement.

In this post, we provide a brief introduction to the concept of moral hazard, focusing on how various aspects of the financial system are designed to mitigate the challenges it causes....

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Truth or consequences: Ponzi schemes and other frauds

In the financial world, the real scandal is often what’s legal, but you still have to watch out for fraudsters. If you don’t pay the costs of screening and monitoring your financial counterparties, you may lose your house.

The never-ending need for financial vigilance came to mind recently when we noticed that the 1920 home of Charles Ponzi was for sale in Lexington Massachusetts. It’s a very large house – 7 bedrooms, 6 bathrooms, 7000 square feet of space (650 square meters) on nearly an acre of land (0.4 hectares).(You can see a picture here.) ...
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