This is “Moral Hazard”, section 8.4 from the book Finance, Banking, and Money (v. 1.0).
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Adverse selection is precontractual asymmetric information. 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 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.
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.http://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 covenantsClauses in loan contracts that restrict the uses to which borrowed funds can be put and otherwise direct borrower behavior., 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.http://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,http://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.