I. Basic Ideas of ‘Moral Hazard’
What is the Moral Hazard?
The meaning of ‘Hazard’, which is similar to ‘Risk’, is close to the ’cause that leads to the risk’ rather than ‘risk itself’. Moral hazards are conditions that may lead a person to intentionally cause or exaggerate a loss. The threat from moral hazard is the possibility that the insured may intentionally cause a loss or file a false claim. For example, an insured may intentionally cause a fire or an auto accident to collect a claim payment on a building or car and unjustly enrich himself or herself.
Why does Moral hazard occur?
Moral hazard easily occurs when information asymmetry exists. For example, after an insurance agreement, the insured person can deliberately make decision that damages to his counterparty because the insurer has less information about the insured person’s action or intention. It can also occur when incentive systems that make stakeholders observe laws or agreement are not well established. If there is a loop-hole in the law stakeholders come to abuse it.. However, though the laws and systems are perfect, if the level of people’s morality or responsibility can’t follow them, moral hazard is inevitable.
What’s the effect of Moral hazard?
Moral hazard causes stakeholders, especially the financial consumers like shareholders, a loss and the effect spreads to the third party. Moreover, if the pursuit of one’s own interest which asking costs of the public benefit prevails, allocation of the resources is distorted and overall economic inefficiency are deepened. Additionally, moral hazard that occurred in part of economy system can be easily diffused to another part by learning effect.
Ways of preventing Moral Hazard
One way of preventing moral hazard is to open and share the information. It can help settle the matter of information asymmetry. Government can also control moral hazard with regulations. For example, government can lead individuals’ action to desirable direction by imposing a tax upon the decisions increasing risk and subsidizing the actions reducing risk. Informal things like reputation, confidence, and ethicality can play important role in preventing problems resulted from moral hazard.
II. Moral Hazard & FSC’s Policy
FSC has various plans for improving financial system. According to the press release in Feb 11, there are six main projects FSC concentrating on. Whatever they seem to, their goal is establishing robust financial system and protecting inventors.
Strengthening regulation for soundness
In the latest financial crisis, many banks became insolvent, and colossal government funds were put into them. it’s resulted from the limit of capacity of capital buffer and absence of a liquidity standard. So, FSC reached the agreement on strengthening regulation on capital(Basel Ⅱ) and introducing a liquidity standard. These policies will make financial system more transparent and keep banks or other financial institutions from going to inappropriate direction.
Laying out a scheme for SIFI (Systemically Important Financial Institution)
Because of their influence on real economy, government put enormous public funds into “too big to fail” financial institutions. However, if precautions are not taken against it, it will occur again. To reduce the expected SIFI’s moral hazard, FSC came to an agreement on building an international system for reorganizing insolvent SIFI and strengthening supervision.
Reinforcing regulation on compensation system
Compensation system is one of main issues of moral hazard. It’s asymmetrical structure has stimulated excessive risk taking and broken its stability. FSC is trying to reform financial companies’ compensation system for executives to reflect risk-taking and long-term prospective of the company based on FSB’s suggested standards for sound compensation system. In this passion, On Jan 7, FSC established an examplary standard for domestic implementation by each financial sector.
Improving accounting standard
Increase of off balance sheet engagements have had bad influence on the confidency of financial information. Besides, There have been some troubles in comparing financial information among nations because of the absence of unified accounting standard information. By this reason, FSC agreed to apply the IFRS(International Financial Reporting Standards) until Jun, 2011. It will give more accurate financial information to foreign investors.
Strengthening regulation on OTC derivatives market
Lack of regulations and supervision on OTC derivatives market amplified the financial crisis. To deal with this problem, FSC reached an agreement on enhancing transparency and reducing counterparty risk. For this, All transactions of OTC derivatives should be reported and traded only through an exchange or electronic platform before CCP(Central Counter Party) is established. CCP is planned to be established until 2012 and large capital will be imposed on the transaction that is not traded through CCP.
Establishing effective ways to apportion the cost in financial crisis
The latest financial crisis asked enormous public funds and it became a heavy burden of the national finance. All taxpayers came to bear this burden. It is unfair that most of the people suffer from few people’s moral hazard. For that reason, need for sharing the cost arose to lighten the burden. Ways to pay their own expenses are also discussed not to incur these kinds of events again. In America, plan to collect ‘Financial Crisis Responsibility Fee’ is released on Jan 14. To walk in step with this trend, Korea is going to requested a plan for it to IMF before April, 2010.
Under all of these policies, matter of moral hazard lies because all activities are done by people. If all people are altruistic, problems will not happen. However, economics assumes that all the people pursuit their own interest and so does the real world. As soon as blind points are discovered, all the people are trying to take advantage of them. In this aspect the financially developed country can be defined as one that is equipped with good system to control people’s immorality. “Korea Discount”, dishonorable nickname of Korea, seems to be originated from the absence of these systems. However, Korea is striving to transform into “Korea Premium” armed with developed system and it will come true before long, through curbing moral hazard.