Learning Objectives
- What is moral hazard and how can it be mitigated?
Moral hazard is postcontractual asymmetric information.
It occurs whenever a borrower or insured entity (an approved
borrower or policyholder, not a mere applicant) engages in
behaviors that are not in the best interest of the lender or
insurer. If a borrower uses a bank loan to buy lottery tickets
instead of Treasuries, as agreed upon with the lender, that’s moral
hazard. If an insured person leaves the door of his or her home or
car unlocked or lets candles burn all night unattended, that’s
moral hazard. It’s also moral hazard if a borrower fails to repay a
loan when he or she has the wherewithal to do so, or if an insured
driver fakes an accident.
We call such behavior moral hazard because it was long
thought to indicate a lack of morals or character and in a sense it
does. But thinking about the problem in those terms does not help
to mitigate it. We all have a price. How high that price is
can’t be easily determined and may indeed change, but offered
enough money, every human being (except maybe Gandhi, prophets, and
saints) will engage in immoral activities for personal gain if
given the chance. It’s tempting indeed to put other people’s
money at risk. As we’ve learned, the more risk, the more reward.
Why not borrow money to put to risk? If the rewards come, the
principal and interest are easily repaid. If the rewards don’t
come, the borrower defaults and suffers but little. Back in the
day, as they say, borrowers who didn’t repay their loans were
thrown into jail until they paid up. Three problems eventually
ended that practice. First, it is difficult to earn money to repay
the loan when you’re imprisoned! (The original assumption was that
the borrower had the money but wouldn’t cough it up.) Second, not
everyone defaults on a loan due to moral hazard. Bad luck, a soft
economy, and/or poor execution can turn the best business plan to
mush. Third, lenders are almost as culpable as the borrowers for
moral hazard if they don’t take steps to try to mitigate it. A
locked door, an old adage goes, keeps an honest man honest. Don’t
tempt people, in other words, and most won’t rob you. There are
locks against moral hazard. They are not foolproof but they get the
job done most of the time.
Stop and Think Box
Investment banks engage in many activities, two of which,
research and underwriting, have created conflicts of interest. The
customers of ibanks’ research activities, investors, want unbiased
information. The customers of ibanks’ underwriting activities, bond
issuers, want optimistic reports. A few years back, problems arose
when the interests of bond issuers, who provided ibanks with most
of their profits, began to supersede the interests of investors.
Specifically, ibank managers forced their research departments to
avoid making negative or controversial comments about clients. The
situation grew worse during the Internet stock mania of the late
1990s, when ibank research analysts like Jack Grubman (a Dickensian
name but true!) of Citigroup (then Salomon Smith Barney) made
outrageous claims about the value of high-tech companies. That in
itself wasn’t evil because everyone makes mistakes. What raised
hackles was that the private e-mails of those same analysts
indicated that they thought the companies they were hyping were
extremely weak. And most were. What sort of problem does this
particular conflict of interest represent? How does it injure the
economy? What can be done to rectify the problem?
This is an example of asymmetric information and, more
specifically, moral hazard. Investors contracted with the ibanks
for unbiased investment research but instead received extremely
biased advice that induced them to pay too much for securities,
particularly the equities of weak tech companies. As a result, the
efficiency of our financial markets decreased as resources went to
firms that did not deserve them and could not put them to their
most highly valued use. That, of course, injured economic growth.
One way to solve this problem would be to allow ibanks to engage in
securities underwriting or research, but not both. That would make
ibanks less profitable, though, as doing both creates economies of
scope. (That’s why ibanks got into the business of selling research
in the first place.) Another solution is to create a “Chinese wall”
within each ibank between their research and underwriting
departments. This apparent reference to the Great Wall of China,
which despite its grandeur was repeatedly breached by “barbarian”
invaders with help from insiders, also belies that strategy’s
weakness.en.Wikipedia.org/wiki/Great_Wall_of_China
If the wall is so high that it is impenetrable, then the economies
of scope are diminished to the vanishing point. If the wall is low
or porous, then the conflict of interest can again arise. Rational
expectations and transparency could help here. Investors now know
(or at least could/should know) that ibanks can provide biased
research reports and hence should remain wary. Government
regulations could help here by mandating that ibanks completely and
accurately disclose their interests in the companies that they
research and evaluate. That extra transparency would then allow
investors to discount rosy prognostications that appear to be
driven by ibanks’ underwriting interests. The Global Legal
Settlement of 2002, which was brokered by Eliot Spitzer (then New
York State Attorney General and New York’s governor until he ran
into a little moral hazard problem himself!), bans spinning,
requires investment banks to sever the links between underwriting
and research, and slapped a $1.4 billion fine on the ten largest
ibanks.
The main weapon against moral hazard is monitoring, which is
just a fancy term for paying attention! No matter how well
they have screened (reduced adverse selection), lenders and
insurers cannot contract and forget. They have to make sure that
their customers do not use the superior information inherent in
their situation to take advantage. Banks have a particularly easy
and powerful way of doing this: watching checking accounts. Banks
rarely provide cash loans because the temptation of running off
with the money, the moral hazard, would be too high. Instead, they
credit the amount of the loan to a checking account upon which the
borrower can draw funds. (This procedure has a second positive
feature for banks called compensatory balances. A loan for, say, $1
million does not leave the bank at once but does so only gradually.
That raises the effective interest rate because the borrower pays
interest on the total sum, not just that drawn out of the bank.)
The bank can then watch to ensure that the borrower is using the
funds appropriately. Most loans contain
restrictive covenants, clauses that specify in
great detail how the loan is to be used and how the borrower is to
behave. If the borrower breaks one or more covenants, the
entire loan may fall due immediately. Covenants may require that
the borrower obtain life insurance, that he or she keep collateral
in good condition, or that various business ratios be kept within
certain parameters.www.toolkit.cch.com/text/P06_7100.asp
Often, loans will contain covenants requiring borrowers to provide
lenders with various types of information, including audited
financial reports, thus minimizing the lender’s monitoring
costs.
Another powerful way of reducing moral hazard is to align
incentives. That can be done by making sure the borrower or
insured has some skin in the game,www.answers.com/topic/skin-in-the-game
that he, she, or it will suffer if a loan goes bad or a loss is
incurred. That will induce the borrower or insured to behave in the
lender’s or insurer’s best interest. Collateral, property
pledged for the repayment of a loan, is a good way to reduce moral
hazard. Borrowers don’t take kindly to losing, say, their
homes. Also, the more equity they have—in their home or business or
investment portfolio—the harder they will fight to keep from losing
it. Some will still default, but not purposely. In other words, the
higher one’s net worth (market value of assets minus market value
of liabilities), the less likely one is to default, which could
trigger bankruptcy proceedings that would reduce or even wipe out
the borrower’s net worth. This is why, by the way, it is sometimes
alleged that you have to have money to borrow money. That isn’t
literally true, of course. What is true is that owning assets free
and clear of debt makes it much easier to borrow.
Similarly, insurers long ago learned that they should insure
only a part of the value of a ship, car, home, or life. That is
why they insist on deductibles or co-insurance. If you will
lose nothing if you total your car, you might attempt that
late-night trip on icy roads or sign up for a demolition derby. If
an accident will cost you $500 (deductible) or 20 percent of the
costs of the damage (co-insurance), you will think twice or thrice
before doing something risky with your car.
When it comes to reducing moral hazard, financial intermediaries
have advantages over individuals. Monitoring is not cheap.
Indeed, economists sometimes refer to it as “costly state
verification.” Economies of scale give intermediaries an upper
hand. Monitoring is also not easy, so specialization and expertise
also render financial intermediaries more efficient than
individuals at reducing moral hazard. If nothing else, financial
intermediaries can afford to hire the best legal talent to frighten
the devil out of would-be scammers. Borrowers can no longer be
imprisoned for defaulting, but they can go to prison for fraud.
Statutes against fraud are one way that the government helps to
chop at the second head of the asymmetric information Cerberus.
Financial intermediaries also have monitoring advantages over
markets. Bondholder A will try to free-ride on Bondholder B, who
will gladly let Bondholder C suffer the costs of state
verification, and all of them hope that the government will do the
dirty work. In the end, nobody may monitor the bond issuer.
KEY TAKEAWAYS
- Moral hazard is postcontractual asymmetric information.
- Moral hazard can be mitigated by monitoring counterparties
after contracting.
