Why is moral hazard so prevalent in the financial services industry?
Moral hazard tends to be prevalent in the financial services industry due to the nature of the industry, temptation and greed, and incentives for employees. Moral hazard is, essentially, irresponsible risk taking. An individual takes more risks, even knowing the potential consequences, because he knows that he will not be responsible for bearing those consequences. In terms of financial transactions, moral hazard occurs when one individual or party takes action that causes detriment to another individual or party in a financial transaction. The cause for moral hazard is asymmetric information, where one individual has more information than the other, information that puts the second person at a disadvantage in decision making. The party with more information has a tendency or incentive to act in an inappropriate fashion to obtain a financial reward.
The financial services industry's primary function is money management. Commercial banks form the foundation on which this industry stands. Such businesses issue credit cards, guard deposits and lend money. Ultimately, the banking industry is not inherently moral. The focus of the industry is making money, not doing the morally right thing. It is more likely for those in this industry to take actions that generate money without regard to moral considerations. For example, bank employees have an incentive to sign up as many individuals as possible for credit cards, as they receive a bonus for each credit card that is issued. The employee knows that the bank and the customer to whom the card is issued will suffer the consequences of any subsequent default on the credit card, rather than the employee.
Part of the problem is the severity of the level of temptation in a business that handles transactions involving large amounts of money. Even a very small amount of insider information can put someone working for an investment bank in a position to make a small fortune by taking advantage of that information. It is almost unreasonable to expect someone to not take advantage of such an opportunity to gain a financial windfall. Individuals are more likely to act without regard to morality when it is relatively unlikely that they will suffer any consequences for their actions.
Instituting employee compensation plans that are geared more toward encouraging morally proper behavior can provide one solution to the problem of moral hazard in the financial services industry. The structure of stockbrokers' compensation packages is typically such that they are inclined to encourage their clients to buy large amounts of stocks, regardless of the soundness of the investments. There is virtually no incentive for them to urge caution or careful analysis to their clients. This situation can easily be altered by changing compensation packages so that a broker receives greater reward based on his clients' financial success rather than the amount of transactions that he generates.
To reduce the risk level of moral hazard in the financial services industry, the key is to realize how inherent moral hazard is in the industry. Facing this basic fact will allow financial services companies to initiate policies to counteract the inherent moral hazard risk.