Constant vigilance is the sole defence against corporate moral hazard

When companies fail, the investigative eyes of audit usually look at fraud issues, scenarios whereby executives or other stakeholders benefit financially. The key issue investigated is conflicts of interest. The company in which you serve as chairman entered into a transaction with a company in which you have a beneficial interest? Well, let us take a look into that.
Important as such issues are, they really are not the major source of mismanagement of companies.
A far more insidious problem is moral hazard. There are two conventionally accepted measures for moral hazard:
. One party has information that the other party cannot reasonably acquire;
. One party can take decisions and benefit from any positive outcome, but negative outcomes are borne by others.
In the first case, the damage to a company is not direct but there is a longer term cost.
As an example, let us assume that an investment company owns a real estate company. The real estate company has launched a project that depends on clients buying off-plan properties.
When the parent investment company realises that the project is going to flop, it decides to list the real estate subsidiary to cover the loss.
If this manoeuvre works, the investment company avoids a massive loss. The problem is that the loss is not reversed, it is instead passed on to the public. A short-term financial crisis is averted, but the cost is the long-term destruction of the investment firm's reputation that leads to expensive funding costs down the line. Worse, there is a long-term destruction of the reputation of the local equity markets, leading to expensive funding costs for all companies in the economy.
The more direct damage occurs with the second type of moral hazard.
A good example is the recent global financial collapse. Investment firms around the world leveraged themselves tremendously by using funding from commercial banks. If the investment bets of these firms worked out, then they would make large profits, and their employees would be paid handsome bonuses.
On the other hand, if these investment firms lost their money, then the fact that governments worldwide deemed it important that they not fail meant that these governments paid for the losses. Money that could have been used productively elsewhere in the government budget was diverted to bail out incompetent or unethical investment firms.
It can sometimes be difficult to understand that rogue management can be so callous. Perhaps some examples from the personal world might help to explain matters.
Have you ever seen someone misbehave in a hotel room even though they are quite well behaved in their own homes?
How about someone over-revving the engine of a car simply because it is a rental?
How about a manager who has an expense account paying far less attention to his spending than he does when it is his own personal account?
In corporate terms, one of the greatest examples of moral hazard is off-plan purchases of real estate assets. Continuing the example above, retail clients who pay for off-plan purchases do not really want to invest in real estate development. They want an existing apartment that they pay for after they move into it.
But when the market as a whole moves to off-plan purchases, what you get is moral hazard.
Think of it this way: there are two parts of the off-plan purchase. The first part is the sale of a real estate investment at the pre-construction phase. The second part is the purchase of a completed residential unit using a mortgage.
The risk in the first part of the off-plan transaction is much higher, so much so that regulators would normally consider it a sale of a real estate investment to a retail client. In cases where it is approved, the sales process must be run by an investment firm registered with the regulator.
The moral hazard here is that if a developer sells a non-existent residential unit directly to a retail investor, there is no regulated intermediary to vet the deal and retail investors will have little real recourse to get their money back, but are providing cheap funding to the real estate developer.
Moral hazard plays a large part in the destruction of corporations and indeed the economy.
Eternal vigilance in holding people accountable for their actions is the only real defence.
Sabah Al Binali is an active investor and entrepreneurial leader, with a track record of financing, building and growing companies in the Mena region. You can read more of his thoughts at al-binali.com.