Moral Hazard Risk Research Articles

Contingent Capital: An In-Depth Discussion

Regulators have embraced the idea of pre-arranging bank recapitalizations through (funded or unfunded) contingent capital issuance. Contingent capital is intended to be triggered when a bank is headed toward failure in order to provide an automatic equity injection that keeps the bank out of distress. This note discusses counterparty risk, effectiveness, moral hazard, contagion and systemic risk, as well as death-spiral issues arising from the hedging strategies of the investors. We pay attention to important design issues with respect to the trigger and conversion ratio and comment on their pricing from an equity and credit derivative perspective.

Economic Drivers of Structural Change in the Global Financial Services Industry

Consolidation has been a fact of life in the financial services sector in recent years, and these structural changes in the industry have created the ample strategic turbulence that has confronted senior management teams and boards of banks, insurance companies, asset managers and securities firms. The drivers include advances in transaction and information technologies, regulatory changes, geographic shifts in growth opportunities, and the rapid evolution of client requirements, which have obliged most financial firms to rethink their roles as intermediaries. Many have been acquired, while others have become consolidators, sometimes damaging their own shareholders' interests in the process. Financial sector reconfiguration is likely to accelerate as a result of the global market turbulence that began in 2007, with governments either forcing or encouraging combinations of stronger and weaker banks in an effort to stem the crisis. In the process, financial firms that are ‘systemic’ in nature and had a major role in creating the crisis are likely to come out of it with even larger market shares – a development that is not likely to be healthy for the financial system going forward. Given the levels of socialization of risk represented by the widespread use of public guarantees to firms judged too big or too interconnected to be allowed to fail, how will the associated risk of moral hazard be addressed, and by what types and levels of regulation? What will be the effects - for the shareholder, and for society as a whole? And can a version of ‘the polluter pays’ principle, developed to counter environmental market failure, be employed to promote financial market stability going forward? Through it all, the underlying drivers of global financial intermediation remain basically unchanged, and will reassert themselves once the hurricane has passed. The purpose of this article is to provide a helicopter overview of the key strategic issues that drive strategic successes and failures, and of the empirical evidence available so far, with the aim of answering some key questions. Has consolidation represented a wise choice for the industry? Has bigger - or broader - turned out to be better? Or has it merely served to create a bigger, broader crisis? Along the way, the article provides some sensible frameworks, or roadmaps, of financial intermediation economics that firms can apply in thinking through their own strategic positioning and execution.

‘Judging’ Economists: Economic Expertise in Competition Law Litigation - A European View

The study focuses on the admissibility and assessment of economic expertise in EC competition law litigation. I start by exploring the broader issues raised by the integration of economic expertise in litigation: in particular the risk of moral hazard and adverse selection because of the epistemic asymmetry between judges and experts and the risk of expert bias. The analysis of these problems will bring me to the question of the conception of science and of the relations between science and law that underpins the concept of scientific expertise and, more specifically, economic expertise. I will then identify the extent of the problem of epistemic asymmetry and expert bias by looking to the degree and the locus of the intrusion of economic analysis in competition cases. I will examine the instruments, procedural and substantive, employed by the legal system, in order to mitigate the risks flowing from the epistemic asymmetry and the expert bias claims. First, I will highlight the different institutional and procedural frameworks that were adopted at the European Union level and in some selected member states in order to integrate economic expertise in litigation. My objective will be to understand how these institutional solutions may address each of the identified problems. Second, I will look to 'substantive' law approaches in the adjudication of expertise, such as the development of specific standards for the admissibility and the sufficiency of economic expertise in courts, as an alternative or as an additional option to deal with the challenges raised by economic expertise. The paper will conclude that the possible adverse effects of the epistemic asymmetry and expert bias between judges and experts raise important concerns that the legal systems should tackle. The current procedural/institutional and substantive legal framework governing economic expertise does not however take sufficiently into account important concerns that are specific to economics and other social sciences, such as the preservation of the scientific 'competition' in the supply of economic theory and consequently methodological or assumptions-related pluralism in economic thought. In particular, I will argue against adopting specific standards of admissibility of economic expertise in Europe. This is a US context-specific solution which does not necessarily fit with the specific characteristics of the European legal system. It is also an approach that represents an outdated and partial view of the scientific as well as of the judicial adjudication process.

Present and Future Fiscal Policy Problems in the Czech Republic

This paper is focused - using the example of the Czech Republic since 1993 - on a description of the hidden risks, implicitly existing in the system of public finances duringthe transition period (from a centrally planned towards market economy). The starting assumption is that public budgets have in time of economic transition certain specific functions. These consist explicitly in supporting the transitional process by transferring part of the economic and social costs, attached to it, over time and various categories of population. These functions are to be carried out at time, when the economic performance of those countries tends to be rather poor and the revenue side of the budgets is not buoyant. Since the financial capacity of the budget is restraint, governments try to find ways by which transition functions could be carried out while their financing would not take the form of instant cash outlays. Evidence of the Czech Republic suggests that measures, conceived to meet the expectations attached to the budget in respect to part of the transitional costs, though conceived originally as temporary, tend over time to become of a permanent nature. Issues such as a risk of moral hazard then occur. The analysis also points to the fact that these sorts of phenomena may not be the only factor that contributed to the deterioration of the Czech public finance in recent years. The evidence of fiscal developments in quite a number of transitional economies suggests that elements of these features tend to exist in most of those countries.

Moral Hazard in Campaigns: Do Political Candidates Keep Hiring Their Consultants?

Political consultants play an integral role in modern political campaigns. When candidates hire consultants to assist with their campaign they create a principal-agent relationship with attendant risks of moral hazard. We argue that the promise of a repeated relationship between a consultant and a candidate is a market-based mechanism that can help to align the consultant’s incentives with those of the candidate. We utilize an original dataset of nearly 20,000 matches between candidates and consultants over a ten-year period to understand how candidates take actions designed to reduce agency loss. We find that while a significant number of relationships last for more than one election cycle, the aggregate rate of rehiring never exceeds 50%, and few relationships endure over the long-term. The frequency of re-matching increases with the centrality of consultant services where the potential for and costs of moral hazard are highest. Our paper is the first that focuses on agency costs in the consultant-candidate relationship, and that utilizes longitudinal data to examine how this relationship evolves.

Bad bank(s) and the recapitalisation of the banking sector

With banking sectors worldwide still suffering from the effects of the financial crisis, public discussion of plans to place toxic assets in one or more bad banks has gained steam in recent weeks. The following paper presents a plan how governments can efficiently relieve ailing banks from toxic assets by transferring these assets into a publicly sponsored workout unit, a so-called bad bank. This plan effectively addresses three key challenges. It provides for the transparent removal of toxic assets and gives the banks a fresh start. At the same time, it offers the chance to keep the cost to taxpayers low. In addition, the risk of moral hazard is curtailed.

The valuation of contingent capital with catastrophe risks

The Intergovernmental Panel on Climate Change Fourth Assessment Report (2007) indicates that unanticipated catastrophic events could increase with time because of global warming. Therefore, it seems inadequate to assume that arrival process of catastrophic events follows a pure Poisson process adopted by most previous studies (e.g. [Louberge, H., Kellezi, E., Gilli, M., 1999. Using catastrophe-linked securities to diversify insurance risk: A financial analysis of lCAT bonds. J. Risk Insurance 22, 125–146; Lee, J.-P., Yu, M.-T., 2002. Pricing default-risky CAT bonds with moral hazard and basis risk. J. Risk Insurance 69, 25–44; Cox, H., Fairchild, J., Pedersen, H., 2004. Valuation of structured risk management products. Insurance Math. Econom. 34, 259–272; Jaimungal, S., Wang, T., 2006. Catastrophe options with stochastic interest rates and compound Poisson losses. Insurance Math. Econom., 38, 469–483]. In order to overcome this shortcoming, this paper proposes a doubly stochastic Poisson process to model the arrival process for catastrophic events. Furthermore, we generalize the assumption in the last reference mentioned above to define the general loss function presenting that different specific loss would have different impacts on the drop in stock price. Based on modeling the arrival rates for catastrophe risks, the pricing formulas of contingent capital are derived by the Merton measure. Results of empirical experiments of contingent capital prices as well as sensitivity analyses are presented.

Entrepreneurship, Business Incubation, and External Finance: An Analysis Based on the Theory of Incomplete Contracts

This paper offers an analysis of the arrangements through which business incubators furnish seed finance and entrepreneurial-specific assets based on the theory of incomplete contracts. Specifically, I compare bargaining games in which (i) an investor offers finance under non-verifiability, which can be put to different uses by the entrepreneur, and (ii) an incubator offers a contract bundling financial provision to entrepreneurial-specific business services. The results highlight negative financial and economic consequences of incomplete contracting for entrepreneurship and how business incubation may partially overcome moral hazard risks, fostering investment in marginal firms that would not otherwise obtain funds and reducing the rate of start-up failure.

Adam Smith and the Political Economy of a Modern Financial Crisis

Financial crises have occurred periodically for hundreds of years, and Adam Smith had important insights into their causes. Although by no means all that we know about such crises has been derived from Smith, it is interesting and important to reflect on what he did know and how ignoring his warnings about the creation of excess liquidity has contributed to the current crisis. In addition to the complexity of contemporary finance and the role of central banks and other regulatory institutions, a major difference between Smith's day and ours is the emergence of “moral hazard” as an important policy issue and its corollary, “immoral results.” It is important to realize that the risks of financial crisis, moral hazard, and immoral results cannot be avoided by financial and accounting gimmicks, and that there is no substitute for adequate capital in the creation of liquidity.

Determinants of contract terms for professional services

This study provides evidence on the determinants of contract terms between professional services firms and their clients. Because professional services are typically characterized by a high degree of transactional uncertainty and a double moral hazard risk, contracts can be essential for the creation of incentives to control the behavior of those involved in the service encounter. Based on both agency and organizational theory, hypotheses on the determinants of implementing a specific type of cost contract are developed and tested empirically with respect to management consulting firms. Our results indicate that (1) service characteristics exert a significant impact on the chosen contract type, (2) performance-based contracts may not be optimal, even if service output is measurable and verifiable, and (3) experience-based trust and reputation impact on the choice of controls used in short-term contracts. These results contribute to the field of management accounting by providing insights into the design of management control systems in service organizations.

Moral Hazard and Background Risk in Competitive Insurance Markets

We examine the effect of background risk on competitive insurance markets with moral hazard. If policy‐holders have non‐negative prudence, then background risk does not decrease effort and, when effort increases, expands the set of feasible policies. However, the effect of background risk on equilibrium is indeterminate. We analyse the choice between stock and mutual insurance; mutual insurance is equivalent to a fair policy plus background risk. Our results imply that competitive insurance markets with moral hazard should be dominated by stock insurers.

Choices at the Precipice: Containment and Distribution in Financial Crisis

This article examines the current credit crisis against the background of recent financial meltdowns in wealthy and emerging markets. I argue that resolving systemic financial crises entails a core set of policy decisions that is consistent across recent experience in Asia, Latin America, United Kingdom and United States. First, faced with the possibility of mass defaults, officials must decide whether to adopt case-by-case or blanket solutions. Second, if private contracts must be modified, should modification be mandatory or voluntary? Third and hardest, officials must decide how to allocate losses from crisis: who gets relief, and who pays for it. Emergency crisis containment measures have profound distributional consequences. The current legal framework for crisis resolution makes it much easier to inject billions of dollars in large institutions than to amend residential mortgage contracts. I suggest that this is partly a consequence of treating each crisis as an unprecedented emergency, and of conflating the tasks of prevention and resolution. Cross-country experience reveals that systemic crisis response is necessarily fraught with moral hazard and political risk. Crisis measures often contravene peacetime policy wisdom. But governments and private actors invoke these extraordinary measures routinely. Acknowledging that crises will return, rules will be suspended, and emergency measures will be used should prompt a critical examination of when, how, and to whose benefit.

Deposit insurance and moral hazard problem: the case of Turkish banking system

We investigate the effect of full deposit insurance introduced in 1994 on the financial performance of Turkish commercial banks. We construct a model, under reasonable assumptions, with deposit insurance where banks undertake excessive risk – moral hazard risk. Empirical investigation using experimental design approach supports our moral hazard hypothesis. Our findings indicate that banks subject to the moral hazard behaviour show significant increases in foreign exchange position risk and deterioration in capital adequacy relative to their benchmark after introduction of full deposit insurance system. We relate this excessive risk-taking to the moral hazard behaviour by commercial banks. The research results indicate that complete deposit insurance system distorts the incentive structure of commercial banks and thus, prevents proper functioning of market discipline mechanism and leads to the taking excessive risk-taking.

Regulating risk: A measured response to the banking crisis

This paper argues that regulatory responses to the sub-prime crisis ought to be guided by the fundamental principle that bank regulation is justified by the adverse consequences of banks taking excessive risks. It therefore proposes three reforms: requiring banks to retain a proportion of any loan that they originate, so as to reduce the risks of moral hazard; insisting that the risks involved in the financial products in which banks trade are transparent; and reforming Basel II so that the amounts of regulatory capital that banks are required to hold are less pro-cyclical than is currently the case.

Safe banking to avoid moral hazard

This paper argues that the moral hazard risk faced by a banking or non-banking firm can be dissipated by arbitrage trading in a market economy. This implies an optimal policy for (a) discontinuation of government insurance, regulation or bank intervention and (b) promotion of market-based safe banks that only invest in government securities and universal banks that invest in all assets. Safe banks can serve panic-prone depositors and thus minimise the systemic risk faced by an economy due to banking panics and runs. The risk premium on assets of a leveraged firm can be shown to be negatively related to asset volatility. The minimum asset-to-debt ratio threshold below which a firm goes bankrupt is an increasing function of the asset risk premium.

On the Sorting of Physicians Across Medical Occupations

We model the sorting of medical students across medical occupations and identify a mechanism that explains the possibility of differential productivity across occupations. The model combines moral hazard and matching of physicians and occupations with pre-matching investments. In equilibrium assortative matching takes place; more able physicians join occupations less exposed to moral hazard risk, face more powerful performance incentives, and are more productive. Under-consumption of health services relative to the first best allocation increases with occupational (moral hazard) risk. Occupations with risk above a given threshold are not viable. The model offers an explanation for the persistence of distortions in the mix of health care services offered, the differential impact of malpractice risk across occupations, and the recent growth in medical specialization.

Business Familiarity as Risk Mitigation in Software Development Outsourcing Contracts

This study examines the role of business familiarity in determining how software development outsourcing projects are managed and priced to address risks. Increased business familiarity suggests both more prior knowledge, and hence reduced adverse selection risk, and increased implied trust about future behavior, and hence implied reduced moral hazard risk. Preferring high business familiarity partners may also alleviate concerns about incomplete contracts. By reducing these risks, higher business familiarity is hypothesized to be associated with higher priced projects, reduced penalties, and an increased tendency to contract on a time and materials rather than a fixed price basis. These hypotheses were examined with objective contractual legal data from contracts made by a leading international bank. Integrating trust theory into agency theory and into incomplete contract theory and examining unique contract data, the contribution of the study is to show that the premium on business familiarity and the trust it implies is not in directly affecting price, but, rather, in changing how the relationship is managed toward a tendency to sign time and materials contracts. Implications about integrating trust into agency theory and incomplete contract theory, as well as implications regarding trust premiums and software development outsourcing, are discussed.

The Long-Term Care Insurance Market

This paper focuses on the existence of an insurance market for long-term care. There are three major risks for insurers that provide long-term care insurance: risk of escalating costs, risk of adverse selection and risk of moral hazard. Despite these risks, the long-term care insurance is a potentially expanding market for insurance companies able to innovate and design products tailored to this very specific demand.

Cooperative ventures in emerging economies

Foreign market entry strategy involves choices about which markets to enter and how to do it. Most of the literature on foreign direct investment reflects an interest in ownership structure decisions and the risks foreign investing firm may face. As recognized in many studies, one set of risks arises from public expropriation hazards, a function of the ability of the host country's institutional environment to credibly commit to a given policy or regulatory regime. Empirical research has shown this hazard to have an impact on ownership levels. This study is a theoretical model that describes how multinational firms face moral hazard risk from their local partners and political risk from the host country when they decide to go abroad in a joint-venture alliance. I found that the greater the level of hazard expropriation, the lower the participation of the multinational firm in the final cash flow, except for when the multinational firm has the negotiation power and there is a high level of local investment protectionism. In that case, the multinational firm increases its participation in the final cash flow.

Tuition Inflation, Prepayment Programs, and the Mispricing of Tuition Prepayment Contracts

Twenty-two states and a consortium of more than 250 private colleges have designed tuition prepayment contracts to help families manage their tuition inflation risk exposure by prepaying the future cost of college. Nine of these states have either suspended enrollments (one temporarily) or terminated their plans, and at least 12 programs are balance-sheet insolvent. This paper analyzes college tuition inflation, describes tuition prepayment contracts, and develops a contingent-claims model to price them. The model allows for the adverse selection risk that program sponsors face, the moral hazard risk that contract purchasers bear, and the large discontinuous jumps that characterize tuition inflation especially in recent years. I find that the contracts in the largest, most popular public (Florida and Michigan) and private (Independent 529 Plan) programs are mispriced. The Florida and Independent 529 Plan contracts are underpriced, and Michigan's contracts are underpriced for the youngest beneficiaries and overpriced for the oldest beneficiaries even after allowing for adverse selection risk. Florida and Michigan have reduced their underpricing in the last three years, which coincide with public universities in many states announcing large jumps in tuition in response to cutbacks in state subsidies for higher education.