Behavioral finance FAQ / Glossary (Moral)

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Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
i: incidental

Moral

08/6i + see ethics, altruism

Moral hazard



01/1i,9i - 02/1i - 04/6i,10i
+ see asymmetry, unintended

consequence, perverse effect,
ethics, cheating, deception,
overreliance on regulation

An opportunist's temptation.

Definition:

A moral hazard is a cheating opportunity and more precisely an available
possibility that is available in a system to take an unfair

advantage.

It is a door (usually a backdoor) that is
(involuntary in most cases) left open for cheating.

The flawed / vulnerable system might be a situation, a society,
an organization, a regulation, a type of contract, a type of benefit..
.


It allows individuals (or institutions, corporations, groups...) to take actions
that give them an undeserved
benefit at the expense of other people and/or
of the economy / collectivity as a whole.


The unintended consequences / perverse effects (see that phrase) of moral
hazards are known as free rides, poaching, loopholes, and also what economists
call, in their poetic language, negative externalities...


Why are those doors open?

Those vulnerabilities often results from a l ack of foresight  by
those who either devised the system
or are in charge of running or
monitoring it.

This neglect could take two forms:

While they considered their decision, practice or rule as wise and useful,
   they
did not spot the counterproductive opportunities available to

free riders coming through the backdoor.

Or if they spotted those possibilities to cheat, they considered them as minor
   and acceptable. Better keep it simple and flexible, at least at the start!

Is morality / ethics always at stake?

In other words, is it an ... immoral hazard?


Behind this risk / temptation / habit to take advantage of a moral hazard,
or even to "beat / game the system" by looking for such loopholes, there is:

Either a clear intention of cheating (see that word),

for example by giving false information when signing a contract or
claiming money.

Or just an instinctive practice to use an open or half open
   door. Just curiosity and a taste for doing something different!

Or one considered normal - even smart and why not
   fair and  equitable.

Maybe the "user" who seize such an opportunity find it as a rather innocuous
and normal way to get
some compensation. and "rebalance" a system
that it sees as bringing an abusive personal disadvantage

* It might consider, rightly or not, the system as unfair and thus to beat it as 
   fair
, and even as a duty.

* It might also feel to be above the little fray (see narcissism) and
   deserve therefore specific benefits (power is said to corrupt those who get
   it).

To label that attitude as ethical or unethical, honest or dishonest, opportune or
perverse would then be a matter of proportion and circumstance.

How far should the prevention against it go?

Locking all doors and windows?


OK, to leave the door of a system open can become a call to opportunism and
robbery.

But on the other hand, to close it tightly deprives it of oxygen and makes it
inadaptable to evolutions and special cases.

The cursor has to be positioned wisely so that the system is relatively flexible
but relatively secure.

As seen above, some responsibility is often shared by the authority
that installed inadvertently the possibility because of a lack of information,
analysis, foresight, caution (see unintended consequence) or courage.

Usually that institution was looking for an immediate result  (maybe rightly
needed but maybe also a makeshift improvisation with a short time horizon),
not caring much about what would happen later.

Of course, this possibility of counterproductive outcomes should not
lead the people in charge to freeze their initiatives
.

A fanatical application of the "precautionary principle" 
freezes innovations, or at least brings overly
bureaucratic controls and regulations.

Also, too much fear of a moral hazard should not bring
endless discussions before applying a quick remedy,
however imperfect, to an emergency.

Nothing can be completely predicted, therefore some rights to experiment
should be left, with a possibility to adjust things later according to results.

Also no system should be too rigid or complicated,. It should be
understandable by the users and have some flexibility to adapt decisions
to situations.

General economic cases

Free lunches.

The opportunistic behavior linked to moral hazards might become generalized

when, for example:

Some common resources are too easily available for free .

Some social regulations open the doors too much and without control to
    welfare entitlements.

Some underpriced or subsidized goods, services or grants can be
    obtained quasi automatically.

It would then result in a huge waste of resources that become
overused

Specific financial examples

Tempting holes in the safe box.

The bank "capital adequacy ratio" was a two edged
   regulation.

It incited banks to limit the needed equity (the numerator of the
equation) by playing hide and seek with the amount
of loan
outstanding (the denominator) in their balance sheet.

This was done by selling to "vehicles" and to not too legitimate
investment funds (shadow banking) huge amounts of credits,
preferably dubious loans, packaged as securities.

Then they could go on granting other junk loans and sell them in
their turn.

This accumulation of toxic assets in every corners of the financial
system was one of the causes of the 2007-2011 global financial
crisis (see below the "market manipulators" section, and also the
"overconfidence in regulation" glossary article).

Btw, this ratio has now been raised by the "Basel III" rules.

An incentive to find new loopholes?
A boost for shadow banking?


Firms / banks / private lenders and even States are sometimes bailed
    out  
by the community, even if the mistakes or
    excessive
risk-takings was theirs.

Of course when the risk is systemic, when the whole economy or a
big part of society is at stake, there can be no other solution.

But this encourages similar firms, or the whole industry in the future,
to take huge risks (if it works, I gain, if it doesn't work, others
will pay the bill)
,

Similarly, bubbles might be encouraged when most players see

central banks as a financial / economic safety tool.

They get overconfident, as they feel that those motherly institutions
have  no other choice than to create money to avoid an economic
recession or a financial crash.


Executives and traders rewarded by fat bonuses for

   quick financial performance might take excessive risk with the
   company's
money as if they will share some of the cream added to
   the cake in case of gains,
while not having to share its loss of
   substance if it turns rotten.


Some subscribers of insurance contracts know (asymmetry of

information)  that their risk for the insurer is higher than the
premium paid.

It might happen that most subscribers be high risk people, so there
is no mutual
repartition with those with lower risk.

As those safer ones do not see the need to subscribe, it results in an
"adverse selection"
with an accumulation of losses for the insurer.


Market manipulators (see manipulation) can find a fraud

opportunity in a specific asset, even an individual stock, or an
asset class
.

A spectacular example was the highly defective securitization
and derivative practices on which was built what became the
"subprime loan crisis" (see above
the "capital adequacy ratio"
and also the bubble / crash glossary article)

This possibility to cheat is usually not opened to the small fry, who
has few chances to "beat the system".


Manipulators might bait other people by offering apparent
    possibilities
to take advantage of a loophole.

They arrange a trap for people naive enough to be tempted
by their red herring or "free lunch".

The famous "Nigerian scam letter", which tempts people to receive a
fat commission by helping an illegal (and illusive) money transfer is a
textbook case.

The Internet can be a tool for financial dishonesties: watch your
mailbox for spams offering you to "make money fast" in the market
or off-market.

The best an investor can do is to

* avoid to fall into too many traps,

* and maybe spot by itself some opportunities that others
   did not
see because of narrow thinking.

Moral hypocrisy

08/6i

Moral hypocrisy is to deceive people with lofty moral statements that
disguise
the real intentions (agenda) or behaviors of those who issue
those statements)

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This page last update: 22/08/15  

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