Repercussions of unchecked incentive problems

THE financial system is the set of markets and intermediaries used by households, firms and the government to implement financial decisions. One of its important functions is to facilitate the efficient allocation of resources and risks.

Funds flow through the financial system from entities that have a surplus to those with a deficit. With proper competition, funds should flow to more productive and innovative endeavors. Society benefits from the best distribution of an economy’s scarce resources.

An incentive, meanwhile, is anything that motivates a person to do something. Economic incentives are financial motivations for people to take certain actions. In their classic analysis of financial systems, however, Robert Merton and Zvi Bodie noted that there were incentive problems that limited the functions of markets and intermediaries.

Incentive problems arise because parties to contract often cannot easily monitor or control one another.

These take on different forms like moral hazards and principalagent problems.

Merton and Bodie highlighted the importance of asymmetric information — when one party to a financial transaction has information that the other party does not have or when one party is an agent that decides for another. In the real world, information will range from the transparent to the opaque. Left alone, the system will not ensure that decisions are optimal.

Let’s review a recent controversy, the sacking of some bureaucrats over their decision to import sugar.

We don’t know the whole story but one side claims to have acted in good faith because the signals they received authorized them to respond to an impending economic emergency. The other side, meanwhile, claims usurpation of authority. Unless we can attribute malice, this is clearly a case of information asymmetry.

Even with correct information, moral hazards produce undesired actions. The moral hazard problem exists when having insurance against risk causes the insured party to take greater risks or to take less care in preventing an event that gives rise to a possible loss.

Again, let us illustrate through the government’s budget process. A benefit of the separation of power between the executive and the legislative is that it provides checks and balances that will ensure scrutiny of budget proposals for the greater public good. In recent times, however, certain executive offices with large budget proposals have been afforded the benefit of summary approvals without any questions being raised. Allegedly, Congress is exercising rudimentary courtesy.

However, doesn’t this practice lead to a moral hazard situation as the proposing executive body gets its budget approved no matter how good or bad a job it does? There is less incentive to be more scrupulous in budget allocation, no matter what the good intentions are.

One way of viewing this incentive problem is through the principal-agent relationship. For example, shareholders in a corporation delegate the running of the firm to managers. Through the electoral process, representatives in Congress had been put in place to act on behalf of their constituents, the people.

Those who bear the risks associated with the decision are the principals and those who assume

the decision-making authority are called agents. In this case, are the agents making the same decisions that principals would have made? Is there conflict of interest?

A well-functioning financial system facilitates the resolution of incentive problems so that the other benefits of the financial system can be achieved. Market failure occurs when the desired outcomes are not met. The incentive problems of information asymmetry, moral hazard and agency are lead reasons. Other causes are risks, high transaction costs and irrational human behavior.

Another illustration: With rising interest rates, borrowers are confronted with having to pay more for their loans. They borrow just the same, however, in the hope that they can use the money productively to earn enough profits to cover their costs.

The adjustment on the lending side happens quickly but are we seeing a similar rise in the savings rate? In theory, banks should raise interest rates to encourage more people to save, also increasing the pool of funds available for lending. Interest rates are the reward for deferring gratification. There is a lag in reaction that has pained savers.

There are grave consequences when the incentive problem issues go awry and market failure sets in.

When the desired outcomes are not achieved, society suffers. Financial instability and higher inequality set in.

In an unfair world, some people suffer more while a few benefit. For this reason, awareness of incentive issues represents a step forward in the quest for more equity and fairness. The challenge is to overcome the ill effects of market and system failure.

Benel de la Paz Lagua was previously EVP and chief development officer at the Development Bank of the Philippines. He is an active Finex member and an advocate of risk-based lending for SMEs. Today, he is an independent director in progressive banks and some NGOs. The views expressed herein are his own and do not necessarily reflect the opinion of his office as well as Finex.