Moral Hazard: The Achilles Heel of Corporate Governance

When companies fail, the investigative eye of audit usually looks at fraud issues, scenarios whereby executives or other stakeholders benefit financially. The key issue investigated is conflicts of interest. The company in which you serve as Chairman entered into a transaction with a company in which you have beneficial interest? Well, let us take a look into that!

Important as such issues are, they really are not the major source of mismanagement of companies. A far more insidious problem is moral hazard. There are two conventionally accepted measures for moral hazard: 1. One party has information that the other party cannot reasonably acquire, and 2. One party can take decisions and benefit from any positive outcome but negative outcomes are borne by others (see the Principal — Agent problem as one example).

In the first case the damage to a company is not direct but there is a longer term cost. As an example let us assume that an investment company owns a real estate company. The real estate company has launched a project that depends on clients buying off plan properties. When the plan fails, the parent investment company decides to list the real estate subsidiary to cover the funding gap.

If this maneuver works, the investment company avoids a massive loss. The problem is that the loss is not reversed, it is instead passed on to the public. A short term financial crisis is averted but the cost is the long term destruction of reputation of the investment firm that leads to expensive funding costs down the line. Worse, there is a long term destruction of reputation of the local equity markets, leading to expensive funding costs for all companies in the economy.

The more direct damage occurs with the second type of moral hazard. A good example is the recent global financial collapse. Investment firms around the world leveraged themselves tremendously using funding from commercial banks. If the investment bets of these firms worked out, then they would make large profits, and their employees would be paid handsome bonuses.

On the other hand, if these investment firms lost their money, then the fact that governments world wide deemed it important that they not fail meant that these governments paid for the losses. Money that could have been used productively elsewhere in the government budget was diverted to bail out incompetent or unethical investment firms.

It can sometimes be difficult to understand that rogue management can be so callous. Perhaps some examples from the personal world might help explain matters.

Have you ever seen someone misbehave in a hotel room even though they are quite well behaved in their own homes?

How about someone over revving the engine of a car simply because it is a rental?

How about a manager who has an expense account paying far less attention to his spending than he does when it is his own personal account?

In corporate terms one of the greatest examples of moral hazard is off plan purchases of real estate assets. Continuing the example above, retail clients who pay for off plan purchases do not really want to invest in real estate development. They want to pay for an existing apartment that they pay for after they move into it. But when the market as a whole moves to off plan purchases and the regulators allow it what you get is moral hazard.

Think of it this way, there are two parts of the off plan purchase. The first part is the sale of a real estate investment at the pre-construction phase. The second part is the purchase of a completed residential unit using a mortgage.

The risk in the first part of the off plan transaction is much higher, so much so that regulators would normally consider it a sale of a real estate investment to a retail client. Such investments are usually banned by regulators from being sold to retail investors and in the rare cases that it is approved the sales process must be run by an investment firm registered with the regulator.

The moral hazard here is that if a developer sells a nonexistent residential unit directly to a retail investor, there is no regulated intermediary to vet the deal and retail investors will have little real recourse to get their money back, but providing cheap funding to the real estate developer.

Moral hazard plays a large part in the destruction of corporations and indeed the economy. Eternal vigilance in holding people accountable for their actions is the only real defence.

This article was originally published in The National.