Moral Hindrance: Sub-optimal Risk Under Excessive Liability

Abstract:

While economists have tended to focus on moral hazard, it is the opposite problem of moral hindrance that is far more likely to plague low-income credit markets. This is the central argument of this paper, supported by a rather straightforward application of economic theory. The total cost of default borne by borrowers, including social, psychological, and other non-appropriable forms of sanction, is likely to be excessive, giving rise to sub-optimal risk-taking and excessive effort on the part of borrowers. Because non-appropriable forms of sanction are strictly less efficient than pledged collateral, sanctions that induce first-best effort are already too high. Unfortunately, public and policy focus on minimizing interest rates has the effect of ratcheting up these sanctions, doing much harm to borrower welfare in the process. Policy should rather promote competition among lenders, encourage broader use of collateral, and allow interest rates to rise as necessary to meet borrower demand for varying loan conditions.

Last updated on 10/27/2012