Moral hazard and the Guyana regulatory meltdown
Moral hazard
When a sectoral regulatory authority, in this instance for the insurance sector, takes the position that regulatory intervention as prescribed by law would be prejudicial to a party that is involved in regulatory evasion and abuse, because such intervention “would have precipitated the demise of the company to the immediate detriment of policy holders,” it means one of two ghastly things, both of which reveal a deeply flawed legal-regulatory-institutional oversight framework.
First, the regulatory provision is obviously flawed. And, if this is the case, then the regulatory authority has a bounden duty to secure the timely amendment of it. Secondly, such regulatory inaction encourages ‘moral hazard.’ That is, offending firms can operate with impunity because of the certainty that violation of the legal provision has no regulatory consequences. This is an appalling situation for Guyana to find itself in, at this time of collapse of global financial markets, due largely to weak regulation and oversight of past years.
Ponzi scheme
Readers should by now be fully aware that the galloping global financial crisis, credit crunch, and economic recession are taking a heavy toll on the financial sector of Caricom. In Guyana, the effective collapse of CLICO (Guyana), as well as the cloud hanging over Hand-in-Hand Trust Corporation, the New Building Society and the National Insurance Scheme, all have their origins in the global crisis, which has put Ponzi-like swindles under immense financial/economic stresses. The implosion of the CL Financial Group (Trinidad) and the wrecking of the Stanford Financial Group (Antigua) fall into this category.
With Ponzi schemes, as long as new investors are coming into the enterprise, all appears well. Better-than-average rewards are paid to early investors, which encourages new investors. An apparently virtuous cycle of new funds, high rates of return, and satisfied investors is set in motion. Once the inflow of new funds is halted, the fraudulent basis of these schemes becomes obvious. This inflow of funds was abruptly halted last September, as the global financial crisis emerged.
With the global crisis, most firms and wealthy individuals became less well-off. Some sought to recover their monies from these schemes. As their numbers grew, the inflow of new funds dried up, leading to firm failure. Only government intervention (‘bailout’) could prevent legal liquidation and/or administration by the courts of these firms. Investors lose. Immense personal tragedies ensue as life savings evaporate. But, it is the case that only governments with very deep pockets can afford bailouts.
Greed and panic
At this stage it is useful to recount that history has conclusively shown that the two worst behavioural traits to be found in capitalist financial markets are greed and panic. Greed is driven by the objective of making as large a profit as soon as possible, and to do so at all costs. Making a profit, therefore, justifies any means by which this is attained. With this outlook, illegality and immorality become the norm.
Not only individual investors and owner managed firms, but corporate firms through their agents (executives and managers) develop a culture of anything goes. In such circumstances, greed becomes systemic. Business ethics go by the board. Unthinkable excesses occur. Systematic evasion of the checks and balances institutionalised in regulatory and legal provisions becomes routinized. It is this greed that lay behind the Enron exposures of a few years ago and now the Madoff and Stanford frauds.
However, it is precisely to protect against such abuses caused by greed that countries have institutional-legal-regulatory and oversight frameworks.
Panic
Panic is as destructive as greed. The major difference is that greed is more insidious. It is, however, no less damaging. Panic stems from irrational behaviours aimed at protecting one’s wealth and income. Like greed, this is true for individual investors, self-owned (mainly small and medium-sized) enterprises, as well as corporate firms, whose stockholders assign agents to run their business.
At this point, it should be recalled that the main benefit from capitalist markets lies in what economists term the ‘animal spirits’ or ‘entrepreneurial drive’ these markets produce in order to do things smarter, better, more efficiently, more productively, and therefore, more profitably. With such ‘animal spirits’ around, there is an inherent risk of panic.
Panic is both irrational and contagious. This can be clearly seen when something starts a panic reaction in a herd of animals and then how quickly this can spread like a contagion throughout the entire herd. Indeed, there are many instances where such panicked herds run headlong to their death, literally stampeding over the edges of cliffs. Again, the regulatory system should be designed to short-circuit such self-destructive actions.
‘Credible’
The earlier references to moral hazard, panic, and greed, link to the equally fundamental consideration of how credible markets view governmental actions pertaining to the economy. All successfully functioning financial markets require clear laws, rules, regulations, and efficient institutions to ensure their effective implementation. Together, these comprise the overall regulatory and oversight framework.
I shall address this matter more fully in my next column. It is important, however, to note at this stage that for this framework to operate effectively government and its economic authorities have to be perceived as credible. If they are not, then when rules and regulations are issued, individuals and firms in the market will not act on them.
Next week I shall continue from this point by reflecting on the crisis of credibility, which the government and its economic functionaries face in Guyana today.