Credit Risk and Moral Hazard
Basel (2000) defines credit risk as the risk given default of a borrower or a counterparty
failing to meet its obligation. The paper identifies credit risk as the largest share of risk in
banks. Thus the need to balance risk and return trade off. Moral hazard is defined as the
assumption of greater risk than would have been the case were the party to be held
accountable for their action or information they provide.
In banking, moral hazard occurs in several ways. Firstly, moral hazard may occur from a
rating agency providing misleading information to lending entities. Secondly, in the event of
systemic risk, governments may decide to bail out the banking sector to stem the total
collapse of the industry, or rather bail out banks that if were to collapse would lead to
macroeconomic instability. In the latter, big and influential banks would have the incentive
to assume too much risk on the backdrop of being: ‘too big to fail’. However, this view has
been challenged by Allen et al (2015), who question whether public bailout is detrimental to
the financial system. Their analysis concludes that well designed government guarantees can
be effective in stemming instability, they provide evidence that government guarantees do
not always lead to higher bank risk appetites and that taxes and other policy instruments may
be at the disposal of governments to correct market distortions if any.
Finally, banking sector ownership leads to the principal-agency problem. Managers are
tasked with controlling banking firms while shareholders own the banks. Managers are
incentivized by performance based contracts and may assume excess risk as they target short
term returns as opposed to shareholders that value long term growth. This situation leads to
moral hazard with shareholders having limited information on banks’ products, processes
and procedures.
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A blatant depiction of moral hazard; where one firm rates assets and clients but the banks are
eventually responsible for their risk levels and asset quality. Basel (2000) avers that pre-
crises practice was the mechanistic reliance on credit rating agencies. International regulation
was justified by standardizing the credit rating mechanism and inherently placing risk
assessment in the banks purview, to determine capital levels given their asset quality and risk
profile. The aspect of moral hazard is further highlighted by innovation in banking sector
regulation, leading to the rise of bail-in concept. Avgouleas and Goodheart (2015), describe
the bail-in approaches as regimes requiring the participation of creditors. A bank’s creditors
are ideally preferential creditors in the event of liquidation. They demand a return on
invested funds with little regard for the bank’s internal processes. It can be observed that a
form of moral hazard creeps in by way of high returns during economic boom and guaranteed
returns in the event of collapse. Bail-ins have been identified as an innovative way to replace
less favorable bail outs.
Rating agencies have also come under scrutiny after sovereign bond defaults by
governments. Traditionally, sovereign debts were considered low risk to no risk. However,
this veil was lifted by successive sovereign defaults. Banks operating at international scale
had sizeable investments in government bonds and often understated their risk based on a no
risk framework. It was assumed that sovereigns would be bailed out by supranational
institutions, for instance World Bank and IMF. Such assumptions on risk would be
detrimental to private capital channeled to public use. Increased regulatory framework led to
banks’ lending to governments at the cost of private businesses.
Mitigating Credit Risk and Moral Hazard
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Credit risk and moral hazard can be reduced by more standardization in risk measurement,
more regulation and disclosure, capital buffers and innovation. For instance standardization
in the recent past has been achieved by the implementation of IFRS standards. In credit
management, IFRS 9 has been introduced that caters for greater standardization in reporting,
granularity in the measurement of risks and incorporation of macroeconomic Forward
Looking Information, as opposed to the prior use of historical data that led to inaccurate risk
metrics. Farkas (2016), in studying the interaction of IFRS 9 and financial stability notes that
increased disclosure by banks are likely to lead to greater market disciple thus enhancing
financial stability.
In addressing the principal-agent problem and moral hazard arising as a result, adoption of
corporate governance structures is deemed appropriate. The financial crisis of 2008 exposed
the underbelly of global financial institutions in terms of corporate governance. While asset
prices rose due to the growth in asset prices, corporations in the financial sector were
flatfooted in internal controls and risk management systems. Kirkpatrick (2009) presents a
case of mismatch between incentives, risk and internal controls. He further opines that some
firms were able to avoid firm wide exposure and risk by effective communication of
qualitative and quantitative information more effectively and engaging in effective dialogue
across management teams.
Corporate governance is defined by OECD (2004) as procedures and processes according to
which an organization is directed and controlled. The corporate governance structure
specifies the distribution of rights and responsibilities among the different participants in the
organization – such as the board, managers, shareholders and other stakeholders – and lays
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down the rules and procedures for decision-making. In determining the purview of corporate
governance, the institution takes into account the benefits of a corporation in creation of jobs,
generation of taxes, provision of goods and services as well as securing savings and
retirement benefits. This provides a wide view of corporate governance. This concept leads
to banking institutions not only being accountable to their shareholders but to the industry at
large.
Regulation can be viewed as an external intervention to stem credit risk and moral hazard
while strengthening corporate governance can be an internal measure to curb the risks. This
two prong approach would serve as a system of checks and balances, distributing
responsibilities across the banking sector spectrum of stakeholders.
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