WHAT IS A MORAL HAZARD?
It is commonplace that companies over-commit, over-sell, and over-promise in an effort to make a sale, and in a broader context to steal a march on the competition.
When this behavior is acted out knowingly, however, it creates a moral hazard that an executive leadership group driven by an ethical construct that goes beyond a fixation with the bottom line can not countenance and must move to stop dead in its tracks. A moral hazard arises, therefore, when a party to a transaction acts in bad faith knowing full well that the risk of such an action is borne by the other party. A moral hazard taken to an extreme can lead to criminal behavior.
A MORAL HAZARD LIKE NO OTHER
The subprime mortgage crisis, which began in 2007, racked up roughly $200 billion in defaulted mortgages. The crisis also violently convulsed the credit markets. Fannie Mae and Freddie Mac, government sponsored enterprises chartered to provide a stable supply of mortgage money for home buyers, sucked in $200 billion in order to remain solvent. The consequences of the crisis were so widespread that it could not spare many of the presumed titans of Wall Street: Bear Stearns, one of the largest underwriters of mortgage bonds, was bought by JP Morgan Chase for approximately seven cents on the dollar. Washington Mutual, the nations’s largest savings and loan, was also bought by JP Morgan Chase, for approximately three cents on the dollar from its price a year before. Merrill Lynch was bought by Bank America in a shotgun wedding over a weekend (facilitated by much strong-arming by the federal government, the deal was approved by shareholders who were falsely told that Merrill Lynch executive bonuses of as much as $5.5 billion would not be paid without the bank’s consent when in fact the bonuses had already been authorized). AIG, the largest insurance carrier in the nation with much of its portfolio in mortgage-related products, and a casino operation that hedged exotic debt instruments, had to be bailed out with a $180 billion loan by the federal government (ultimately repaid by AIG including a $23 billion profit to taxpayers). And, Lehman Brothers, one of the most exposed banks to the subprime mortgage market, went out of business after 160 years.
Moral hazards were on display during the subprime debacle courtesy not just of financial institutions but of others as well. Home buyers bore a great deal of the responsibility for the fiasco by lying about their incomes, and living beyond their means; mortgage brokers who were incented to sell high-risk mortgages; mortgage underwriters who processed applications without full documentation; the failure of regulators who lowered capital lending requirements, and overrode anti-predatory state laws; credit rating agencies which rated mortgage-backed junk as AAA securities, and so forth. The real estate bubble, fueled by artificially low interest rates, merely provided the tipping point for the crisis. Whatever the attribution of the crisis is assumed to be, however, in the end it was a failure to serve.
There is always the potential to give rise to a moral hazard anytime one party to a transaction has an incentive to behave against the interests of another party. Moral hazards can be mitigated somewhat by regulations but, in the end, regulation spells out the lowest common denominator of acceptable behavior. And, besides, regulations do not provide enough of a deterrent to keep crooked individuals on the straight and narrow. Consider that only one Wall Street banker went to jail for fraud (although lesser luminaries did end up in the slammer and some are still behind bars). In most recorded cases of fraud and abuse, it’s important to remember, there were laws on the books to preclude the offensive behavior.
Moral hazards can also be mitigated by the presence of contracts that are fair and balanced and which give as much as they take. Unfortunately, the preponderance of marketplace transactions is essentially one-way and invariably favors the supplier. Finally, the admonition to the consumer of caveat emptor is helpful but hardly practicable in the rapid-fire of day-to-day commercial transactions.
THE SERVICE ETHIC: A SUPPLIER OBLIGATION
The acts of fraud and abuse perpetrated by corporations and others are the result of individuals operating in an ethical vacuum. All of the regulations in the world, therefore, will not prevent fraud. Remember, there were plenty of regulations in place at the time of Bernard Madoff’s $65 billion Ponzi scheme. Similarly, there were regulations in place at the time of Enron’s fraud. In that case, CFO Andrew Fastow chose to break the rules with his financial shell game.
The consequences of ethical misconduct are real and severe and will, in time, doom the mightiest enterprise. Adelphia Communications, Arthur Andersen, Tyco, Qwest, Wachovia, and Worldcom are but a few of the names which were eventually cut down to size for their continued arrogance in the face of flagrant moral, and ultimately illegal, misbehavior. Unfortunately, the comeuppance suffered by these malefactors is little consolation to the millions of consumers who lost their jobs, their homes, and their hard-earned life-savings at the hands of these unscrupulous predators. Still, the depredations continue. Wells Fargo was recently ordered to pay $185 million in fines and penalties for opening unauthorized deposit and credit card accounts. Wells Fargo seems to revel in a culture of deceit and appears hard-wired to cheat. Since 2000, according to Violation Tracker, Wells Fargo has been fined nearly $11.5 billion for sixty one different abuses.
A world without Madoffs or Fastows – a world perhaps chimerical – has a chance of succeeding only when ethical behavior is the pervasive culture in business. The onus to treat the consumer fairly, therefore, rests squarely with the supplier which abides a service ethic. The Service Ethic refers to those principles and practices that govern how individuals and their organizations behave toward the customer. The Service Ethic rests on three pillars:
- An explicit and unambiguous mission to serve the customer. The mission must clearly and succinctly state that “customers are first.” Commitments to employees, stockholders, and other stakeholders although clearly important in their own right can not purport to represent the raison d’être of the corporation. To serve the customer and the marketplace is the principal reason for the corporation to exist and it must trump all other considerations.
- A lofty mission statement to serve the customer is often nullified by tactical, operational or departmental “fine print.” If the mission to serve the customer, however, is to come to life, no policy, practice or procedure, can be allowed to subvert that mission.
- Adherence to the “golden rule of service.” This implies that the organization will always do what it says it is going to do and conversely never do what it says it is not going to do. A simple adherence to this rule, admittedly difficult at times to enforce, can dramatically improve customer goodwill.
It is gaining more and more currency that consumers focus as much on the integrity of their suppliers as on the quality or price of their products. It is a visionary executive leadership group, moreover, that understands that service excellence driven by an unremitting adherence to the Service Ethic can prove an unassailable competitive advantage in the 21st century while enhancing the moral standing of the corporation.