Moral hazards arise from information asymmetry, where one party cannot fully monitor the other's actions. This lack of observability may lead the unmonitored party to act less cautiously, exposing the other to financial consequences. Moral hazard could occur in the banking sector and it is particularly relevant in the interactions between commercial banks, depositors, borrowers, and broader economic stakeholders.

Commercial banks act as intermediaries, channeling funds from depositors to borrowers. Depositors, such as individual savers, entrust their money to banks expecting secure storage and a modest return. Borrowers, such as corporations, utilize these funds to finance projects aimed at generating revenue. For example, a business may secure a loan to expand operations, upgrade equipment, or adopt new technologies. These investments aim to improve efficiency and profitability, ensuring the borrower's ability to repay the loan with interest.

However, a moral hazard arises when borrowers use the borrowed funds irresponsibly. In the example above, if the business allocates a significant portion of the loan to nonproductive expenses—such as speculative investments unrelated to core operations, excessive executive bonuses, lavish office upgrades, excessive travel, or unnecessary events—these expenditures fail to directly enhance revenue generation. As a result, the business may struggle to generate sufficient cash flow to repay the loan, increasing the risk of default.

When borrowers default on loans, banks face heightened financial risks, as their ability to recover loaned amounts diminishes. If multiple borrowers default simultaneously, depositors may encounter delays or losses in accessing their funds.

In extreme cases, governments may intervene with bailouts. However, this places an economic burden on taxpayers.