Moral hazard is an action that often occurs within a company. The initial use of this term itself had a negative connotation, implying fraud or immoral behavior.
A number of bankers then proposed that the credit restructuring period affected by Covid-19 could be extended again for at least one year. The current economic pressure itself has raised concerns about debtor performance prospects.
Until now, the Financial Services Authority (OJK) is currently reviewing this possibility. In fact, a number of observers have also asked banks to be aware of the potential for moral hazard from debtors if the credit restructuring period affected by Covid-19 is extended again.
What is meant by moral hazard? What are the causes and impacts of moral hazard? How to overcome and prevent moral hazard? You can find all these questions in this article, Mudalovers.
Understanding Moral Hazard
Moral hazard is a risk that a party has not signed a contract in good faith or has provided misleading information regarding assets, liabilities or credit capacity. Kotowitz in The New Palgrave Dictionary of Economics then states that moral hazard is the action of agents in maximizing their utility at the expense of others and in situations where they do not bear all the consequences or do not enjoy the full benefits of these actions.
Moral hazard itself is often used in insurance business terms. Moral hazard is in the form of the possibility of the insurance holder deliberately taking actions that could be detrimental to the goods insured in the hope of getting a replacement claim from the insurance company. The word moral hazard itself is then often used in a banking perspective to refer to the behavior of interested parties (stakeholders) .
Paul Krugman himself stated that the concept of moral hazard has been widely used to explain various behaviors of debtors (borrowers) and credit providers (creditors/banks) who dared to take high risks during the financial crisis that occurred in Southeast Asia in 1997-1998.
Luiz A. Pereira, Silva & Masaru Yoshitomi state that moral hazard is the behavior of interested parties (stakeholders) , for example banks (shareholders and management) or banking debtors, which then creates incentives to have hidden agendas and actions that are contrary to business ethics and laws that apply to his benefit.
These interested parties are on behalf of the corporation, or for the benefit of the corporation, based on work relationships or other relationships, within the scope of the corporation’s business, either individually or together.
Read Also : What are Risk Assets? Definition, Types, Examples, and How to Reduce Losses
History of Moral Hazard
The term moral hazard itself originates from the 17th century and was widely used by British insurance companies in the late 19th century by Dembe and Boden. The concept of moral hazard was the subject of new research by economists in the 1960s and then implied immoral or fraudulent behavior.
Economists use the term moral hazard to describe the inefficiencies that can occur when risks are displaced or cannot be fully evaluated, rather than a description of the ethics or morals of the parties involved. Until now, moral hazard is often identified with behavior in the form of fraud committed by individuals or groups. Fraud tends to be directed towards the economic sector, such as insurance, banking, and the like.
How to Overcome Moral Hazard
Basically, moral hazard can be overcome. The following are ways to overcome moral hazard quoted from various sources:
Building Motivation or Incentives
This can be seen in insurance, to avoid the danger of moral hazard, insurance companies will design contracts to provide incentives for customers to insure a product. They also will not insure the full amount, where there is also a process for paying the first down payment from an insurance claim. Insurance companies will also make the process of getting money difficult, so insurance users will be more reluctant to submit claims.
Punish Bad Behavior
The government can then provide bank guarantees and punish those responsible for making reckless decisions, such as individual pay-for-performance decisions. This means, to avoid the danger of moral hazard in the labor market, some form of performance evaluation is carried out and there is no guarantee of lifelong employment.
In simple terms, giving punishment to those who intend to carry out moral hazard. That way, moral hazard actions can be overcome optimally.
Read Also : What is an Audit? Definition, Types, Functions and Benefits
Preventing Moral Hazard in Banking
Taswin Ibrahim and Ragimun in a journal entitled Moral Hazard and its Prevention in the Banking Industry in Indonesia then wrote about efforts to prevent moral hazard, namely
- Strengthening regulations for reducing the value of guarantees by implementing risk-based guarantee premiums.
- There needs to be restrictions on bank ownership.
- Disciplinary levies for the market can be carried out through information transparency as well as reducing the value of deposit guarantees.
- Implementation of risk-based management or supervision.
The application of risk management in banking itself needs to comply with the principles:
1. Transparency, or Risk Management Policies that Must Be Transparent
By doing this, all potential risks must be explained openly. This hidden risk will then become a source of big problems in the future.
2. Correct Assessment
This means that it must be based on an accurate assessment methodology. Companies then need to make sustainable investments to be able to continuously develop various concepts, methodologies, tools and techniques to then build strong risk management.
3. Quality and timely information
This needs to be done because it will support assessment accuracy and quality measurements for decision making.
4. Diversification
By doing this, dangerous risks for banks can be overcome.
5. Independence
What this means is that risk management must be based on independence in the relationship between each unit in the organization.
6. Disciplined Decision Patterns
What this means is that no matter how good the concepts, methodology, tools and techniques used are, the quality of decisions on risk depends on how management decides how best to use the available concepts, methodologies, tools and techniques. Therefore, the decision-making process must then refer to a standard pattern that is followed with high discipline.
7. Determination of Banking Limits and Risk Tolerance
Setting limits will then provide maximum certainty in taking risks and narrow the opportunities for moral hazard.
8. Implementation of Internal Control in Every Transaction
By properly controlling each transaction, moral hazard can be prevented.
Causes and Impact of Moral Hazard
Moral hazard in banking can occur due to weaknesses in regulations and legislation, ownership structure factors, deposit insurance and credit lending aspects, as well as weak market discipline.
Therefore, good and stable regulations should be found or created, can be regulated well, do not cause a concentration of economic power, then have the flexibility to grow the banking industry, and have the ability to differentiate between healthy banks and those that are not.
Below are the factors that cause moral hazard:
- Low income: It is believed that the reason why individuals will then participate in moral hazard is due to a lack of income or sufficient resources to control future costs.
- Lack of personal or moral values
- Lack of personal values that uphold honesty is sometimes a factor that encourages someone to commit moral hazard.
- The mismatch of information between the principal and agent then gives rise to what is usually called a conflict of interest where each party then tries their best to maximize each other’s profits.
The Impact of Moral Hazard
Moral hazard also refers to a situation that then arises when an individual has the opportunity to take advantage of various agreements or financial situations, knowing that all risks and impacts will then fall on the other party. This means that one party is open to the option – and therefore tempted – to take advantage of the other party.
The second party itself is the party who bears all the consequences of every risk that is then taken in a moral hazard situation, leaving the first party free to do whatever they want, without fear of responsibility. They are able to ignore all moral implications and act in a way that is most beneficial to themselves. The impacts of moral hazard include:
1. Cost Overruns
Cost overruns that are not within budget Individuals who bear the burden of risk will spend more than budgeted for the same risk because of moral hazard.
2. Conflicts of Interest and Legal Cases
Moral hazard also results in conflicts of interest and legal cases when both parties later learn of various missing information.
3. Triggers Corruption
One of the main impacts of moral hazard is corruption. Individuals who are willing to maximize their profits from activities that don’t cost a penny.
Moral Hazard and its Prevention in the Banking Industry in Indonesia
The banking industry is a unique industry compared to other industries. In this case, other industries, such as profit-oriented industries, this industry also carries out a supervisory or monitoring role towards debtors. On the other hand, this industry is also monitored by depositors, including regulators and deposit insurance institutions. .
Depositors do not directly monitor the use of funds which are then placed with debtors, but banking institutions that monitor debtors have a role as trustees of depositors or depositors of funds in the bank. This monitoring or control will run as it should when they have aligned interests.
If there is no alignment of incentives and interests between them, a conflict of interest will occur. In fact, it will complicate various monitoring functions, where shareholders can then take high risks at the expense of other shareholders, depositors and deposit insurance institutions.
Therefore, the role of regulations regarding moral hazard is managed well and properly. This needs to be done because it really functions as a public representation related to monitoring in the banking industry.
The case of theft of Citibank customer funds which was then carried out by certain individuals either in their personal names or in certain conspiracies is a clear example of moral hazard in the world of banking in Indonesia.
Read Also : What is the Cash Principle? Definition, Explanation and Comparison with Accrual Accounting
Closing
Moral hazard is an action that should not be taken because it could harm other people or even make a company bankrupt. Therefore, as much as possible we can prevent moral hazard from occurring, so that criminal acts of corruption can be avoided. This is a review of Moral Hazard, starting from the definition, history, steps to overcome it, causes and impacts. Hope it is useful!
Talking about banking, it’s actually not just about law, but also about banking. If you want to look for articles about banking, you can get them at mudabicara.com. To support Mudabicara in broadening their knowledge, Mudabicara always provides quality and original books so that Mudalovers has information.