Moral Hazard: Why Actions Have Consequences

“There's a big difference between small companies failing and big companies failing. When small companies fail, it’s their problem. When big companies fail, it's everyone's problem”. Truer words have never been spoken, especially regarding the Financial Services industry. In real life, and despite the best efforts from regulators and governments, the world is plagued by Moral Hazard.

So, what is a moral hazard, precisely? At its core, it's the jeopardy that individuals or institutions will take on excessive risk because they know they won't bear the full consequences of their actions. In other words, they can engage in precarious conduct and possibly gain massive returns if things go well, but if things go wrong, they won't suffer the full consequences because a “sugar daddy,” generally in the form of government, will swoop in and save them.

Time and time again, and especially in the aftermath of every global crisis, a great deal of soul-searching takes place to eliminate the incidence of moral hazard. Regulations are introduced, new oversight bodies are created, and promises of “accountability and responsibility” and threats of actual “laissez-faire” attitude vis-a-vis company failures are waved around.

But as time passes, many of these reforms get diluted or reversed completely. And the industry returns to its old patterns, and the boom-and-bust cycle remains.

A curious mind would ask, “Why does this keep happening”? And the answer is not an easy one: many factors will need to be taken into consideration:

First and foremost, the absolute complexity of the industry comes into play. The new innovative products, the ever-evolving money-making strategies, the incestuous interconnectedness of the market participants, and the cross-border anticipated reach make it very hard for regulations to keep up with the developing risk profiles.

Second, comes the enormity of the stakes. With trillion-dollar entities and billion-dollar payouts, incentives are higher than ever to outperform and beat the market. The prospective rewards for taking on excessive risks are too appealing for some to resist.

Third comes habit-enabling. In the hope of saving the system from collapse, governments have repeatedly interfered in the form of bail-ins / bailouts. This sent the message that institutions could engage in risky behavior with little fear of consequence. And instead of taming excessive risk-taking, this has induced a vicious cycle of irresponsible behavior that prioritizes the pursuit of profits at all costs. After all, the bigger fish you are, the bigger “Carte-Blanche” you have to do whatever you want.

Finally comes the inherently flawed human nature. What makes us human is precisely what hinders us from optimal decision-making. Greed and blind ambition often haze our judgment and lead us astray.

So, what can be done to end this sequence of moral hazards in the financial services industry? From a regulatory standpoint, the best way forward is to create an anti-fragile financial system, more resilient and less prone to collapse. This can be achieved by setting strict rules regarding leverage, liquidity, solvency, and proprietary portfolio/risk Management. This is further realized by encouraging more diversification, so institutions are less interconnected and less likely to suffer from contagion. It could also involve creating mechanisms for resolving failed institutions in an orderly manner so that the failure of one firm does not bring down the entire system.

But as we all know, regulatory oversight is merely one component of the solution. As the moral hazard dilemma is a battle for the soul of our society, a fundamental shift in the industry culture towards one that promotes stability, ethics, sustainability, and long-term thinking is crucial.

The Financial Services industry needs to come to terms with the fact that each firm must face its challenges and come out stronger or cease being, with either result natural and acceptable: As dinosaurs became extinct when they were met with a catastrophic risk event, many institutions will be deemed to share the same fate. And this is completely fine. Life goes on… but without you.