Moral Hazard in Finance, Essay Example

Moral hazard refers to a situation in which a party to a transaction has not entered the contract in good faith, has provided misleading information, or has an incentive to take unusual risks in the pursuit of profits before the completion of the contract (Investopedia). The recent financial crisis is considered by many to be the worst since the Great Depression and has forced many among us to question the ability of the markets to regulate themselves effectively. One of the reasons why markets do not always function efficiently is the existence of moral hazard.

One of the major contributors to moral hazard in finance is expectation of help/rescue in case things go wrong. Moral hazard exists at both individual and organizational levels. One of the organizations that have been accused of creating moral hazard is IMF which often provides rescue funding to troubled economies as is evident by its rescue of Mexico for $18 billion in 1995. IMF followed by approving lending programs for Thailand, Indonesia, South Korea, and Brazil etc. (Dreher) The expectation that IMF will rescue if things go wrong leads countries to inefficient management of their finances because they do not expect the worst case scenarios to materialize.

Moral hazard also exists due to lack of accountability. As Wharton Finance Professor Richard J. Herring states, the government response to the recent financial crisis has created even more moral hazard because lenders to financial institutions have not suffered the same losses as stockholders. Similarly, another Wharton Finance Professor Franklin Allen claims that the government response has rewarded failure because the largest companies will know in the future that they are “too big to fail”, thus, the government will bail them out if things go wrong. Wharton Finance Professor Marshall E. Blume points out that many people who created the bubble exited the market before the collapse and made huge money (Knowledge@Wharton), thus, they were not held accountable for the mess they created.

Moral hazard also exists because the decision maker doesn’t face the full consequences of his actions. As example is an asset manager who profits by investing others’ money but is not wholly responsible for any loss of capital. Thus, he is more willing to take risky steps in order to earn higher return because his personal gains are directly related to the returns earned by his fund. In other words, the rewards are much greater than the potential costs. Another factor that contributes towards moral hazard are poorly designed incentive systems. During the housing boom, mortgage officers were not compensated on the basis of issuing quality mortgage loans or minimizing risk but instead on the volume. This is why mortgage officers gave little attention to the risk they were creating and more to mortgage loans turnover (Okamoto).

Moral hazard also exists because of conflicts of interest. Credit rating agencies obtain most of their revenues from organizations selling the bonds. During the financial crisis, credit rating agencies assigned Triple A ratings to several deals which ultimately turned out to be quite risky. But credit rating agencies did well at least until 2007, with Moody’s enjoying a sixfold increase in its stock price between 2000 and 2007. While issuing Triple A ratings helped credit rating agencies earn record revenues, they have paid little price for the erroneous ratings they issues which is why there are now calls for increasing the accountability of credit rating agencies (Duyn).

Moral hazard also exists if there is a security net as in the case of FDIC insurance that provides protection on bank deposits up to a certain amount. In this case, banks will take less care in ensuring they do not take excessive risks on deposited funds while consumers will have little incentive to do research on the health of the bank in which their deposits reside.

The recent financial crisis has not only shown us several instances of moral hazard but has also increased the probability of moral hazards in the future. The government has bailed out several banks and financial organizations including Citibank, Goldman Sachs, Morgan Stanley, AIG, and Wells Fargo (ProPublica) which sends message to the markets that the government will always be there as a lender of the last resort, thus, banks and financial institutions have really small probability of going out of business, even in the worst case scenarios.

The government has also increased moral hazard among the general public due to policies that may be politically beneficial but introduce inefficiencies in the economic system. The U.S. Government created Freddie Mac and Fannie Mae to increase home ownership among the American public which is why Freddie Mac and Fannie Mae issued substantial mortgage loans during the housing boom that should not have been made in the first place due to buyers’ credit worthiness. The purpose of these two organizations forces them to ignore certain safety measures that may be taken by private mortgage organizations whose sole purpose is profit maximization.

The concept of moral hazard in finance has existed for centuries now as is evident by financial crisis that occurred in Europe even before the founding of the U.S. There are several factors that increase the probability of moral hazard such as poorly designed incentive systems, lack of accountability, future expectations as a result of events such as financial rescue and bailouts, and conflicts of interest. The key to reducing moral hazards is to increase accountability for decision makers and set precedents such as the failure of Lehman Brothers so that financial organizations know they may be forced to bear the full consequences of their actions.

References

Dreher, Axel. Does the IMF cause moral hazard? A critical review of the evidence. Exeter: School of Business and Economics, University of Exeter, March 2004.

Duyn, Aline van. Reform of rating agencies poses dilemma. 10 June 2010. 21 February 2013 <http://www.ft.com/intl/cms/s/0/a374a2be-74b3-11df-aed7-00144feabdc0.html#axzz2Layp0K2s>.

Investopedia. Moral Hazard. 21 February 2013 <http://www.investopedia.com/terms/m/moralhazard.asp#axzz2LZXLzHF6>.

Knowledge@Wharton. ‘Rewarding Failure’: Will the Crisis Leave a Residue of Moral Hazard? 8 July 2009. 21 February 2013 <http://knowledge.wharton.upenn.edu/article.cfm?articleid=2282>.

Okamoto, Carl S. “After the Bailout: Regulating Systematic Moral Hazard.” UCLA Law Review 2009: 183-236.

ProPublica. Bailout Recipients. 21 February 2013 <http://projects.propublica.org/bailout/list>.