Moral hazard is created by an asymmetry of information after a transaction has been completed.   In the financial markets this is usually in the form of a loan.  There is a risk, a hazard, that the borrower may engage in poor, immoral, decision making, from the lender’s perception, because these actions increase the likelihood that they will not get paid back.  Moral hazard is a part of agency theory.

Here is an example:  You decided to lend $500 to your cousin Jeb because he says he can double that $500 by buying an undervalued guitar for $500 and then selling it on eBay for $1,000, which is still below its value.  Your cousin Jeb knows guitars really well, you know enough about him from his renditions of “Stairway to Heaven” at the family reunions to not have an asymmetry of information there.  So you make the loan to cousin Jeb.  However, you did not know your cousin quite well enough, Jeb also loves to place bets at the dog track.  Once Jeb has the money he may be more tempted to place the $500 you loaned him on the dog Might-Win-This-Time for the 20 to 1 shot down at the track.  The bet has a greater risk and with it a greater reward.  If Jeb wins he gets $10,000 dollars and is able to pay you back your $500 and still get to go buy that dirt bike he has always wanted with the $9,500 he has left.  However, if Jeb loses the $500 on Might-Win-This-Time, which will probably happen (it usually isn’t Might-Win-This-Time’s time), then you will not get paid back and Jeb simply loses your faith in him.  Jeb was probably OK with that considering to him you’re just his turd litle cousin, Jeb isn’t very nice.  If you could’ve followed Jeb around you could’ve discouraged him from betting on Might-Win-This-Time and instead watched him buy the guitar and complete the transaction on eBay.  But, you don’t live near Jeb, and you can not always know what he is doing, you had an asymmetry of information of Jeb’s actions.  That asymmetry of information on Jeb’s whereabouts led to the moral hazard of Jeb betting your loaned money at the dog track.  Because of this moral hazard, even if you really, really believed Jeb would use that money to flip the guitar on eBay, you still may not make him the loan.

Moral hazard can be eliminated by the market and the law.  Financial intermediaries, institutions such as banks, have greater means and expertise to be able to monitor people that they lend to in the market.  You and a financial intermediary could write provisions, restrictive covenants, into your loan contract that restrict the borrower.  The covenants could say the loan can only be used for a certain thing, or that a minimum asset balance be maintained by the borrower, or that information be provided about activities periodically.  The covenant could also require collateral, also known as secured debt, so that if the loan is not paid back then you keep the collateral as payment.  This is like a morgatage on your home, if you don’t pay your morgatge to the bank that gave you the morgatge then they can seize the title to your home and auction it off to pay for what is owed to them.  However, legal fees may be too costly to purse a breaking of these covenants, which is why loans are usually done between financial intermediaries, because they can make use of economics of scale, and in larger denominations.  All of these tools help to make the moral in moral hazard not so hazardous and thus encourage people to make loans and fuel the economy.