Moral Hazard in Banking Industry - Case Study Example

Moral Hazard in Banking Industry affiliation: Executive Summary The paper discusses the problem of moral hazard in relationto the banking industry. In addition, the paper suggests additional guidance on the type of tools and good practices that can help mitigate moral hazard. Moral hazards refer to the tendency of parties taking risks with the belief that they are free of any consequences of their actions. In the case of banking, moral hazards refer to the incentive for increased risks taken by the insured banks that can result when the customers believe that the bank insurance protect them from losses, and therefore they do not have to monitor bank operations. However, effective steps are vital to curtail moral hazards, and the insurers have a mandate to mitigate moral hazards through creating and promoting appropriate incentives for these banks, and their clients through proper discipline. Policy makers strive to balance between moral hazards and financial stability, but during hard times, they tend to protect the customers more. This moral hazard practice became evident after the 2008 economic crisis. Table of Contents 1. Introduction 2. Moral Hazard 3. Qatar National Bank-Background 4. Moral Hazard and Deposit Insurance 5. Guidance on Mitigating Moral Hazard a) Mitigating Moral Hazard b) What the company is doing-Ethical and Social Responsibilities 6. Analysis and Evaluation 7. Methods of Reducing Moral Hazard 8. Financial Crisis and Moral Hazard 9. Recommendations 10. Conclusion 11. References Introduction The year 2008 was a turning point for the banking system after the credit crisis, and in the same year, all governments stressed the importance of effective deposition compensation. According Golin (2010), the governments also argued on the need for an international set of principles for effective insurance practice. By 2011, the Financial Stability Board (FSB) accepted the core principles according to the request by IADA and Basel Committee on Banking Supervision (BCBS). Throughout history, banking has continually posed a moral hazard to the society. However, due to the economic crisis, people continue ignoring the dark side of banking, and they have utterly given in themselves to debt. Every criticism relates to the irrational exuberance of the banking system and not on the inherent and political dangers of the debt. However, different banks have come up with different marketing skills to regain the lost trust from the society especially after the credit crunch. This paper addresses the concerns about moral hazards in the banking industry and its case study bases on Qatar National Bank. Moral Hazard Every banking organization requires a well-designed financial system in order to protect its stability. Having a poor design means increased risk-taking, which may result to moral hazard. Consequently, moral hazard is a concern for safety participants, and the mitigation of moral hazard remains a vital tool of a safety net design. Moral hazard is the inclination of a party whether person or organization to take risks leaving the other party to hold responsibilities for the costs. Banks are simply financial intermediaries maximizing the profit margin subject to constraints, and the market forces play a big role in ensuring the efficiency of financial institutions. Monetary organizations differ through regulation, business costs, and information asymmetries. Besides, they dominated credit supply due to information access from managing deposit accounts. These banks benefitted from regulation to protect their clients, which created moral hazard about lending. The outcome of a rational calculation of risks plays a vital role in bank confidence and trust. Moral hard in the mainstream theory include the unintended effects of insurance as the increasing of willingness to take on risks whether with limits on monitoring. The origins of the moral judgment came from the insurance literature, and according to the decision theory, this opportunism was an outcome of a rational pursuit of selfish ends. There is no ethical connotation of the term moral hazard since it arose once the crisis emerged. Qatar National Bank-Background This bank came from a humble beginning to become a global bank that shows tremendous growth becoming amongst the largest banks in North Africa and Middle East regions. This bank is leading in Qatar, and its market share exceeds 45% of the banking sector assets. Qatar National Bank Group came up in 1964 as the first bank owned by Qatar. However, today this bank has its ownership arrangement joint between the private sector and Qatar Investment Authority. This bank started from the scratch with about 35 employees with the Indian Rupee and the British pound being the currencies in circulation. Earlier in 1965, the Qatar National Bank announced net earnings of QR1.8m. However, by 2013, this bank reported a 13% increase of comparable profits meaning a profit of QR2.4m. In addition, the total assets went up to QR458b, which is a 20.6% increase. Between January and March 2014, Qatar National Bank recorded QR2.4b net profit, which is a 13.7% increase. Its assets recorded at QR458b a 20.6% increase. According to a report by The Peninsula, the explosive growth is due to increase in assets, loans, income, and profits. Explicit deposit insurance is not the only solution, and banks are susceptible to contagion because they borrow short by accepting short demand deposits and accepting lending long. Unless the bank is able to preserve liquidity, it may find itself selling its assets at very low prices, or maybe closing its doors. Although deposit insurers guarantee the depositors of their safety, it equally comes with costs because this encourages the bank to take higher risks due to insurance protection or moral hazard problem. Qatar National Bank like the other banks continues taking excessive risks believing that the government should bail it out in case of any emergencies. This bank’s action is an example a moral hazard. Qatar National Bank practiced subprime lending especially after the credit crunch loaning people who were likely to default their payments. The default was more likely because of the unemployment that came with the credit crunch. The banks introduced higher interest rates to these loans in order to recover. Research shows that many lenders knew that the borrowers would not be able to repay these loans in the end. However, they went ahead and issued the loans due to the high demands. The banks took the risks not caring about the consequences. The banks bore none of the risks because the deposit insurer faced the consequences. In March 2013, Moody put Qatar National bank and other four banks in the Great Cooperation Council (GCC) under scrutiny for possible downgrade. According to Espinoza and Prasad (2010), the main aim of these banks review was to assess the evolving risks, and prudential trends towards imposing losses on their customers in the context of Implementation of Basel and government support. Moody argued that the government held up, and fully supported the banks. However, the government of Qatar took action by acquiring large stakes at the local banks. Analysis and Evaluation Golin (2010) argues that economists describe moral hazards as a situation whereby only one person makes the decision on the type of risk to take with another party bearing the risks. Every country has a Central bank whose duty is mainly to bailout the government and the banks within the region. Therefore, the Central banks play a big role in encouraging the banks to take huge risks since they will not have to carry the full responsibility. Lending institutions should be able to take risks mostly through issuing loans because these loans have higher chances of bringing higher returns. Banks like Qatar National Bank should give out similar loans considering the high returns, and the Central Banks bail out. Unfortunately, these high risks often weigh on the taxpayers, depositors, and other creditors. A report from the World Bank confirmed that the international bank crises that have occurred in the last twenty years had the taxpayers bailing them out. Another area whereby a bank like Qatar National Bank presents moral hazard includes the mortgage securitization. This process of mortgage securitization involves the mortgage originators passing on the risk that they might not repay on the balance sheets, while assuming the risk. The process may involve agents like the government among others to monitor these originators while maintaining the quality of the loan. The financial institutions like the banks structures private agency securitization especially after the credit crunch. Most analysts believed that the moral hazard was the cause of the risks inherent in mortgage during that time. They argued that no one forced borrowers to worry about any loan quality, and despite the spreading problems, everyone undermined the incentive for responsibility. Most finance companies did not care because they did not share similar regulatory with the banking system. The government did not have to bail out anyone and so the taxpayers were not on the hook. Methods of Reducing Moral Hazards Enhanced Guidance The banks should ensure more emphasis on the market discipline from both depositors and shareholders among other creditors. This action may help in moral hazard mitigation, and the banks should place less discipline reliance on the smaller depositors. However, depositor discipline might not be an effective tool the overall solution to moral hazard. Small-scale depositors may have no interest in monitoring these banks. As a result, lack of monitoring may have implications on the bank design in relation to deposit insurance systems, and the level and magnitude during good and bad times. In market discipline, the stakeholders should realize the risks from the large-scale depositors, and they must ensure the insurance of the bank. While market discipline may not be enough to mitigate moral hazards, Golin (2010) notes it helps in regulatory discipline mainly through prudential supervision. It also ensures effective depositor insurance design features. These design features are effective tools because they help in setting rules that limit the scope and level of certain circumstances that help in inspiring depositor discipline. The deposit insurance system may have some authorities to control the entry and exit system, terminate deposit insurance coverage, or use early intervention. The early intervention may include collecting information and monitoring. In addition, this system may pursue civil remedies that will resolve the problem identifying the party at fault. The system may equally conduct resolutions at lower costs while penalizing any bank offering exceedingly high deposit rates in order to attract clients. The banks should adopt relevant safety net participants whose intentions would be developing and implementing early development through coordinated framework. These participants may include foreign authorities especially in cases of cross-border transactions. These participants should have proper coordination and integration, and they should be willing to share information with deposit insurers. Using early intervention and detection tools is an added advantage. In the case of a failing bank, the issues should resolve at minimum costs to the deposit insurer, and without taxpayer responsibility. In addition, the large uninsured depositors should take responsibility while meeting the costs of a bank’s losses. Financial Crisis and Moral Hazards Role of Social Conventions about Confidence The bank’s structure and social convention provide a good base for economic activity. Social conventions equally relate to respect for asset valuation. The societal trust provides a good base for confidence in the bank functions, and in regards to the society, moral values are vital elements for any successful bank activities. Consequently, any immoral or opportunistic behavior undermines the social-economic structures and undermines the functionality of the banks. In financial regulation, which is vital for moral hazard the banking system tends to work best as a decomposable system. The financial regulation’s objective is promoting functionality of the banks against backdrop of inevitable potential for financial instability. In this case, functionality includes the provision of credit facilities and liquidity according to the societal needs. These requirements should build on social conventions that equally build on a history. In addition, these requirements help to strengthen the social structures in banking especially in regulation approach. Because morals are rational, moral hazards revolve on the structure of the banks in relation to the society and consequently with ethics. This relationship means that moral hazards do not involve personality in an atomistic sense. Therefore, from a micro level, moral hazard involves uncertainty among parties’ providence. After all, the full information is never available across the parties because moral hazard includes broader than active information concealment. There should be confidence in other people’s behavior and these banks in order to mitigate the moral hazards. From a societal point of view, moral hazard is the danger that social conventions may corrode the faith and destabilize it. In banking, the financial companies are social entities considering that every person relates with a certain bank, and this is a moral sentiment. Another moral sentiment in relation to banking is that the fairness and social responsibilities are vital drivers on not only profits, but for the opportunistic behavior, that is not the norm. However, it is important to realize that immoral conventions may evolve through misinterpretation of information, and banks encouraging customers to be reckless. On the other hand, regulators like government and other agencies may help reduce some of the immoral practices. There is a need for addressing moral hazards in order for the banks to rebuild trust while creating a climate of confidence in both banks and Central Banks. Addressing moral hazards prevents narrow moral hazards through simple regulatory restriction that flow with the traditional banking culture. The banks like Qatar National Bank should reduce some activities through propriety trading while applying some regulations like liquidity ratios, eligibility to credit cards, and rules on mortgage lending. However, the bank should be careful because some restrictive regulation may create new risks. The government should reassert the banks on the importance of Lenders of Last Result for traditional banking in order to prevent the moral hazards by the Central Banks. Lastly, there is a need for an international all global insurance funds to support these Lenders of Last Result in case of systematic risk. Recommendations The government should not discourage rational behaviors from Qatar National bank and the other banks as long as they base on reason. Therefore, the banks should be able to market themselves, and entice their clients into taking high-risk loans. These loans tend to have higher returns compared to the long-term loans. The government should also set the banks free. In Qatar, the government ensured that it held major stakes with the banks, and hence it has a lot of control on these banks. The government’s interference limits the risks taken by these banks hence the need to back off. On the other hand, the Keynesian law demands that the society should accept that market imperfections are inevitable. Therefore, the most important thing is to improve state governance, and the bank governance, while regulating against risky opportunities. The banks and their stakeholders should change the incentives in order to attract a bigger clientele. This change may include providing bonuses to the depositors and borrowers in order to ensure a reduce some of the moral hazards. Lastly, the Central Banks are the lenders of the last result, which clearly seems to encourage high bank risks. Therefore, the government should place a limit on how much the Central Bank can bail out a failing bank. Setting these limits will instill discipline to the lending banks. However, no solutions may be concrete especially in relation to restoring confidence especially if the probable for financial shakiness remains prevalent. Some evolving tensions in banking contribute to moral hazards. While the central Bank’s lending to the banks increases confidence, it equally reduces the Central Bank’s leverage regarding credit creation. Another major problem leading to moral hazard in banking is the competition and cooperation within the industry. There is no more confidence in the banks, and the free competition leads to higher risks. An increasing bank confidence reduces reserve ration, while increasing the vulnerability. After all, limited reserve banking is unavoidably potentially weak. Conclusion The aim of addressing moral behavior is to change behavior and attitudes in the banking culture through changing of bank structure. The new design should ensure that socially aware behavior remains inevitable and that there is a need for the government to emphasize on governance through monitoring, supervision, and regulation. The banks should ensure that the clients have all the necessary information before deposits or borrowing. Therefore, the banks should embrace a social, cooperative, and ethical banking in order to reduce moral hazards. They should also improve the government knowledge on banking in order to identify cultural problems upfront. The banks should provide a vehicle for promoting a more ethical culture. References Espinoza, R. A., & Prasad, A. (2010). Nonperforming Loans in the GCC Banking System and their Macroeconomic Effects. Washington: International Monetary Fund. Golin, J. L. (2010). The bank credit analysis handbook: A guide for analysts, bankers and investors. Singapore: Wiley. http://thepeninsulaqatar.com/business/qatar-business/287128/qnb-from-humble-beginning-to-a-global-bank Read More