Moral Hazard and Structural Compliance

danger sign

I have been tossing around the concept of structural compliance in my head. The idea is to focus on the alignment of employee incentives with the long term goals of the organization. Jeff Kaplan forwarded me an article he wrote for the April 2009 issue of CCH’s Federal Ethics Report: Boards of Directors, Moral Hazard and Corporate Compliance Programs.

“Moral hazard” is the phenomenon that reducing the effect of risk by providing insurance results in the encouragement of riskier behavior. A party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.

Jeff point out the moral hazard in the economic crisis where individuals creating the risk did not have their interests aligned with those of the organization. I touched on these in my post about Countrywide: Did Compliance Programs Fail During the Financial Industry Meltdown? In that story, we saw that loan officers were compensated more for origination of sub-prime loans than standard loans. They were actually paid more to originate riskier loans. The loan officers were not compensated based on the repayment of the loan. They were isolated from the risk of non-repayment.

One of the problems with the securitization of loans is that the originators do not retain the risk. They originate, sell the loans, and transfer the risk. This continues as the loans are repackaged and tranched up into the collateralized debt food chain. There was a structural compliance failure. The risk was separate from the reward.

With the failure of Lehman Brothers, the term “moral hazard” was a hot topic in the news. If we rescued them, others would expect the financial safety net. (It seems like the government made the wrong decision in deciding to let Lehman fail.) We let people build in flood plains based on government flood insurance and subsidized insurance.

Another case in point is my snowboard helmet, streaked with the brown marks of tree limbs from my runs through trees. I feel safer and take some risks that I would not take without my helmet. My head is safer, but I am more likely to take damage somewhere else or dislocate my elbow (again!).

Part of the compliance program has to focus on making sure that the reporting, governance, and compensation of the people in your organization are tied to the long term goals of the organization.

If you are rewarding people based on short-term goals, then you are going to end up with short-term results. If you are rewarding them for gains and not penalizing them for losses, then they are insulated from the risk. They are likely to make riskier decisions.

Merely running a compliance program to make sure people are following the rules is nice. But it is better to have compliance program that also focuses on removing incentives to break the rules. I think that is what I mean by structural compliance.

See: