Options for Addressing Moral Hazard

Moral hazard is present in deposit insurance systems, as is true of other insurance settings. Greater efforts to contain its effects are needed in many countries if deposit insurance is to be effective. Various methods are available for this purpose, which may be grouped under three headings: (1) good corporate governance and management of individual institutions; (2) market discipline exercised by uninsured depositors and other creditors; and (3) regulatory discipline exercised by supervisors and deposit insurers. All of the methods for controlling moral hazard have potential advantages and disadvantages. Choices among them generally involve trade-offs among competing public-policy objectives and risks, and reflect a variety of factors existing in a particular country. Thus, in choosing among methods for reducing moral hazard, policymakers may wish to consider: (a) the primary objectives of deposit insurance in their country; (b) the conditions that determine the effectiveness of particular methods of curtailing moral hazard; (c) the commitment and the ability of the country to meet these conditions; and (d) progress in advancing a reform agenda to eliminate gaps in the country's ability to implement particular methods. Decisions relating to the design of deposit insurance systems need to take these considerations into account. OPTIONS FOR ADDRESSING MORAL HAZARD This paper represents the work of the Subgroup on Moral Hazard. It is designed for deposit insurance practitioners and other interested parties, and draws on the experience of various countries that have addressed the moral-hazard issue, as well as on the extensive literature on the subject. Moral Hazard and Deposit Insurance Moral hazard refers to the incentive for increased risk-taking that is present in deposit insurance as well as in other kinds of insurance. To the extent that depositors are protected, they have little incentive—and in some cases limited access to the necessary information—to monitor the performance of insured institutions. As a result, in the absence of regulatory or other restraints, funds are available for weak institutions and for high-risk ventures at lower cost than otherwise would be the case. Unless effective steps are taken to curtail moral hazard, the deposit insurance system faces the possibility of increased losses and the economy as a whole may suffer from imbalances if more funds are channeled into high-risk activities. Incentives for increased risk-taking are greatest under a system of blanket guarantees, whereby full protection is provided to all depositors and other stakeholders in response to a financial crisis that threatens the collapse of the financial system. Accordingly, a number of countries with blanket guarantees have moved, or are considering moving, to limited-coverage deposit insurance systems. Even in a limited-coverage system, however, moral hazard remains a concern. Greater efforts are needed in many cases to contain moral hazard by means of the design of the deposit insurance system and the actions of supervisory and deposit insurance authorities. This paper addresses the following questions: • What means of reducing moral hazard are available in principle and what trade-offs are involved in their use? • What means of curtailing moral hazard have been adopted in particular countries and what can be learned from this experience? • What conditions—political, legal, financial, supervisory, resource availability, etc.— may affect the suitability of specific measures to curtail moral hazard in particular countries? 1 The members of the Subgroup on Moral Hazard are officials from the United States (coordinator), Chile, France, Germany, Italy, Japan, and The World Bank. Incentive Effects of Deposit Insurance on Stakeholders of Insured Institutions At the heart of the moral-hazard issue are the incentives provided by deposit insurance to stakeholders—depositors, other creditors, owners, managers and directors—and to bank supervisors and deposit insurers. These incentives differ considerably in different deposit insurance systems—blanket guarantee, implicit, and limited-coverage deposit insurance. The effects on depositors Depositors, as noted above, have little or no incentive to monitor the performance of insured institutions or discipline their risk behaviour in a system of blanket guarantees. A similar situation is likely to exist in an implicit insurance system, although depositors may exercise greater caution if there is uncertainty as to the willingness and capacity of government to provide ad hoc protection when an institution fails. In an explicit, limitedcoverage system, on the other hand, uninsured depositors and other unsecured creditors are aware that they are likely to sustain losses in the event of the failure of an insured institution; they consequently have strong incentives to monitor the performance of their institution and keep their funds in institutions they regard as sound. However, such incentives may be lessened if depositors are able to diversify their holdings among a number of institutions while staying within insurance limits. Whether limiting deposit insurance coverage provides effective depositor discipline depends, of course, on whether the limits are enforced when an institution fails. Also required are strong accounting and disclosure regimes and a financially sophisticated group of depositors able to distinguish between sound and unsound institutions on the basis of available data. The effects on owners Owners also have different incentives under blanket guarantees and limited-coverage deposit insurance. Blanket guarantees generally are issued in response to a financial crisis and often are designed to shield both institutions and their borrowers from losses. In these circumstances, there are few penalties for undertaking excessive risks. In limited-coverage systems, on the other hand, losses and failures are clear possibilities. Although benefiting from the low cost of insured deposits, owners may seek to control an institution's risk in order to protect their investment. Such incentives, however, are weakened if the institution is poorly capitalised or insolvent. Consequently, owners have little or no equity left to lose, and their liability if an institution fails is limited to the amount of their investment. They may then be tempted to put the deposit insurer’s or the government's funds at risk. The effect on managers and directors Managers and directors also may benefit from having access to low-cost insured deposits to fund asset growth. However, because of concerns about their professional reputations and potential liability, they may exercise a restraining influence on excessively risky activities at their institutions. This influence is likely to be greatest in limited-coverage systems when failures are a possibility, particularly if bankruptcy is viewed by the society with disfavour and has significant financial consequences, if inappropriate actions are subject to legal sanctions, and if compensation schemes are consistent with the safe-andprofitable operation of the institution. The effects on supervisors and deposit insurers Supervisors and deposit insurers may encounter serious difficulties in attempting to curtail excessive risk in a system of blanket guarantees adopted in a financial crisis. Actions by supervisors and deposit insurers are likely to be more effective in systems of limited-coverage insurance. Risky behaviour by insured institutions, and the losses that are likely to result from such behaviour, may be curtailed by various regulatory actions as described below. However, provisions may be needed to require, by statute or otherwise, early intervention by supervisors and deposit insurers in the case of troubled institutions. Otherwise, an insolvent institution may be allowed to continue to operate as a result of forbearance or political pressure, with the prospect that losses will be greater when it finally is closed. Methods of Reducing Moral Hazard In principle, various measures are available to curtail moral hazard. They generally fall under the following headings: (1) good corporate governance and management; (2) market discipline exercised by depositors and other creditors; and (3) regulatory discipline exercised by supervisory and, in some countries, deposit insurance authorities. For ease of exposition, these methods are discussed separately in this paper. However, many deposit insurance systems have elements of all three, and these methods are most effective when they work in tandem to curtail moral hazard. Depending on conditions in different countries, the relative importance of, and the reliance placed on, the three methods may vary considerably. As noted later in this paper, some countries may not have conditions that are conducive to controlling moral hazard. Corporate governance and management Among other things, good corporate governance encompasses internal standards, processes, and systems for ensuring appropriate direction and oversight by directors and senior managers, adequate internal controls and audits, risk management, evaluation of the institution's performance, alignment of compensation with sound business objectives, and management of capital and liquidity positions. Good corporate governance and management can help assure that business strategies are consistent with safe-and-sound operations, and thus can act as the first line of defense against excessive risk-taking. However, the effectiveness of corporate governance and management may at times be weakened by competitive pressures or by other external forces that reduce earnings and capital positions. Institutions may then be tempted to reach for yield by undertaking riskier loans and investments. They also may be tempted to reduce expenses by reducing resources for internal controls, audits, risk management, and other processes that help control risk. At the extreme, as noted earlier, owners of an insolvent or barely solvent institution may conclude that they have little to lose by engaging in high-risk activities. Accordingly, efforts to establish good corporate governance and management must be accompanied in most cases by market and/or regulatory discipline if moral hazard is to be contained.