MEMO OF Moral Hazard — group assignment- please see attachment Essay Example

Date: 26 May 2014

Re: Moral hazard issue in financial markets

Moral Hazards are a common issue in financial systems. Moral hazards are mainly linked to the agency problem whereby the two parties, agent and principal are involved. There is an existing relationship between the two parties and the agent is hired so as to act on behalf of the principal. However, what creates moral hazard is where the party has the tendency of taking serious risks since the resulting costs are not likely to be accounted for, by the person taking the risk. Moral Hazard is likely to occur when the actions of a single party may result to the damage of the other after the financial transaction has taken place. After the occurrence of such incidences, individuals or institutions are not always ready to take the full responsibilities for the consequences of their actions. The parties act less carefully and leaving the other party to take responsibility of the consequences of their actions.

Moral hazards are a pervasive and inevitable feature of the financial system and of the economy more generally. A moral hazard is where one party is responsible for the interests of another, but has an incentive to put their own interests first. One classic case is Enron accounting scandal. Enron’s collapse was the result of unethical practices. It used an accounting method known as “mark to market”. With this method, the price or value of a security is recorded on a daily basis to calculate profits and losses. Using this method allowed Enron to count projected earnings from long-term energy contracts as current income. This was money that might not be collected for many years. It is thought that this technique was used to inflate revenue numbers by manipulating projections for future revenue. Using of this technique made it difficult to see how Enron was really making money. The numbers were on the books so the stock prices remained high. Enron misled the public into believing that it was realizing profits from legitimate trading of its nature gas to energy distributors. In fact, all the revenues reported were products of accounting manipulations. The auditor from Anderson Accounting, who was assigned to handle Enron account, turned a blind eye to all these accounting manipulations. When their unethical practices were revealed, Enron filed for bankruptcy within four months. All shareholders and employees faced huge losses. The scandal threatens to undermine confidence in financial markets in the United States and abroad.

Importance of Moral Hazards

One of the biggest importance of Moral Hazard is financial bailout and the idea of too big to fail also represents the moral hazard in financial markets. If the management and the public presume that the company will receive a financial bailout, then it is likely to take up more risks and hence falling out of the market due to unreasonable risks such as panics, crashes and melt down. The other importance of moral hazards is that it encourages strict government control via strict monetary and fiscal policy. After an occurrence of a moral hazard the government always feels obligated to strengthen the loop holes through controls and regulations which are likely to increase moral hazards in the near future.

How to Solve Moral Hazard

One of the best ways in which the issue of Moral Hazard can be addressed is through regulations. Regulation can be done by the government and other local and international firms that ensure ethics is maintained in business sector. Proper monitoring and auditing of the financial statement of the financial records and statement, will go a long way in preventing and solving Moral Hazards and issues related to it.

It is important to realize that Moral Hazard can be solved by auditing and auditing. Accounting theories have proven to be a significant tool in handling moral hazards. Accounting theories involve normative regulatory theories that help improve allocation efficiency hence ensuring fairness for the investors and protecting them against exploitation. Regulation in accounting also prevents the common problem such as the free rider problem, information asymmetry and low network effects that could arise without proper accounting measures. The accounting regulation theories support network effects by increasing returns to shareholders, comparability of financial statements and economies of scale.

Auditing on the other hand has policies that aim at enforcing accounting rules, improving allocation efficiency and guaranteeing fairness for the investors. It is important to understand that both accounting and auditing regulations should be used since they are complementary. The accounting rules and techniques need to be auditable whereas the auditing techniques must also be problem solving and very efficient.

References

CFA Institute, 2007. Moral Hazard and the Role of Central Banks. Available at:
[Online] http://www.cfainstitute.org/learning/products/publications/cp/Pages/cp.v24.n1.4541.aspx [Accessed 26 May 2014].

Ballwieser, W., N.D. Accounting & Auditing: Interaction in the regulation and research domains. Accounting & Auditing: Interaction in the regulation and research domains, 1(1), pp. 1-19.

Kamin , S. B., 2002. Identifying the Role of Moral Hazard in International Financial Markets. Available at:
[Online] http://www.federalreserve.gov/Pubs/Ifdp/2002/736/default.htm [Accessed 26 May 2014].

Obringer, L. A., 2014. How Cooking the Books Works. Available at:
[Online] http://money.howstuffworks.com/cooking-books8.htm [Accessed 27 May 2014].

Richter, L., 2011. A Detailed Look at the Enron Accounting Scandal. Available at:
[Online] http://www.brighthub.com/office/finance/articles/101609.aspx [Accessed 27 May 2014].