With the recent collapse of Silicon Valley Bank, the concept of moral hazard has been getting significant airtime. Don’t take my word for it, just check out the search trend below (and by who – hello, Washington, D.C. policy makers / enforcers!)
Since it’s been a while between economics classes for me, I needed a refresher. Being one of those 100+ searches this week, this is what I discovered.
Moral hazard is a very real problem in the world of finance. It happens when one party in a transaction has an incentive to take more risk than they should, because they know someone else will bear the consequences if things go wrong. For example, a valet is asked to park a classic sports car and they have insurance that covers any damage. That valet might be tempted to drive recklessly, because they’re not required to pay for repairs in the event of a crash. That’s moral hazard.
A similar moral hazard can arise in public corporations, where executives and Boards might act in ways that benefit themselves at the expense of shareholders or other stakeholders. For instance, a management team might take excessive risks with the company’s assets, pay themselves high salaries or bonuses, or engage in fraudulent activities. These actions can harm the value of the company and its reputation, as well as expose it to legal liabilities.
One way to reduce this moral hazard is to align the interests of the individuals entrusted with running a company with those of its shareholders. This can be done by implementing stock ownership guidelines, which require key employees and Board members to own a certain amount of stock in the company or to retain their shares for a certain period. This way, they have a stake in the long-term performance and reputation of the company, and are less likely to gamble with its future.
Stock ownership guidelines are considered a governance best practice and are widely adopted by larger publicly traded companies. However, they could be improved by making them more stringent and transparent. For example, companies could increase the minimum amount and duration of share ownership required for different levels of management and Board members. They could also provide more robust disclosures on how they monitor and enforce compliance with these guidelines and what penalties apply for non-compliance. Although the current regulatory landscape (e.g., Reg. S-K Item 402(b)(2)(xiii)) encourages companies to disclose their ownership guidelines, the SEC has not specified any particular reporting requirement, except to recommend that companies specify “applicable amounts and forms of ownership”. To be clear, both Silicon Valley Bank and Signature Bank disclosed the existence of what appear to be standard industry guidelines in their most recent proxies. However, nothing is known about the rigor applied in setting these guidelines or the ongoing efforts to enforce them.
Making ownership guidelines both stringent and transparent would allow companies to foster a culture of long-term value creation and ethical behavior among their leaders and owners. This could help combat the risks of moral hazard and improve corporate performance and reputation.
Significantly, executive stock ownership requirements are not the lone panacea for moral hazard problems. These programs must be designed carefully to avoid creating unintended incentives or consequences. For example, if stock ownership guidelines are too strict or unrealistic, they might discourage talent from joining or staying with the company. If they are too lenient or flexible, they might not have any meaningful impact on executive behavior.
Therefore, stock ownership guidelines should be designed carefully and tailored to each company’s specific circumstances and objectives. They should also be complemented by other broader measures promoting ethical behavior and accountability among executives and Directors such as effective Board oversight, transparent disclosure, internal controls, audits and whistle-blower protection. More meaningful stock ownership guidelines alone cannot eliminate moral hazard, but they may be part of the solution.