Moral Hazards

Moral hazard is the strange name given to a risk-taking phenomenon that is carried out in every walk of life. When undertaking precarious adventures, we all tend to employ a safety net in case something goes awry. Not simply the classic protection adopted by trapeze artists but also safeguards like wearing seat belts in a car or protective clothing when working with machines; or applying cream in sunny conditions or wearing masks in a pandemic. These defences are sensible approaches to help us mitigate the underlying risks. We seldom see our actions as risk-management tactics but that’s exactly what they are!

In the business world, similar adaptations are used – in addition to financial insurance, which ultimately provides monetary cover when all else fails. Moral hazard addresses situations where businesses see no value in guarding against downside risks because the underwriter of last resort will bail them out. This “magical” underwriter is sometimes the insurance company acting as guarantor or the government in the case of state enterprises or taxpayers in the event of vital utility services.

An academic case study has been devised around the bail outs of Irish banks just over 10 years ago. No accusations are levelled but in trying to explore the concept of moral hazard, it is posited that commercial banks had no incentives to curtail their lending activities because they knew that they could not go bust – the Irish government would surely step in to protect depositors. Whilst the cynicism is obvious, the explanation of moral hazard is exemplary.

However, MMPI contends that we all regularly engage in moral-hazard type  behaviour; sometimes subconsciously but at other times deliberately. Where employers have disciplinary procedures involving two-step warnings before dismissal, employees may be tempted to overstep the mark knowing that a first offence will incur only a yellow card. Fixed salaries, favoured by financial regulators, have the effect of supporting business underperformance. Employees lack motivation to go the extra mile in full knowledge that they will get paid regardless. On the other hand, bonus payments also create problems. Here, employees are enticed to make more sales to improve income for both the company and themselves. They have no incentive to produce quality sales just sales – knowing that adding to the company’s bottom line is not a sackable offence.

Do we take more risks with our driving when we know that we have fully comprehensive cover? Do financial controllers take more liberties with cosmetic financial accounting in order to meet budget targets? Do Managing Directors undertake high-risk business activities where positive outcomes lead to enhanced personal rewards and negative outcomes are accepted passively by shareholders?

The list is endless. Test your own moral compass by examining your personal attitude to risk events. Are you conscious that you ignore certain risk mitigators and rely on somebody else to cover for you? Once you don’t suffer the consequences, whether you know it or not, you are a perpetrator of moral hazard. How does that make you feel?

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