[Rohit Maheshwary and Shrutika Lakhotia are students at Christ (Deemed to be University), Bangalore.]
The vicious cycle of the financial crisis followed by economic meltdown has been a reality for every country. The term ‘financial crisis’ explodes various other terminologies such as “government intervention” and the “problem of moral hazard” which are inextricably intertwined with each other. However, to address the issue of the financial crisis, there is always a toss to bet on - heads, the government intervenes, or tails, it respects the concerns of moral hazard.
This brings us to highlight the recent turmoil in the Indian economy which is a big reason to worry. The pandemic has caused an economic setback to various stakeholders in the form of increasing unemployment, liquidity crunch and business losses among other things. At this juncture, it is important to revive the economy and restore the public confidence by enacting various policies, schemes, or a set of laws/regulations addressing the financial crisis.
This article restricts its study to the recently announced relief package for the Micro Small Medium Enterprise (MSME) sector and the guarantee backed loans. Part 1 discusses the details of the relief package and the need for the government to intervene. Part 2 of the article discusses the implications of the guarantee backed credit to the MSME sector and the problem of moral hazard. Along with this, the article gives a passing reference to the issue of moral hazard as witnessed during the 2007-2008 crises. To conclude, the authors provide an alternative solution to reduce the risk of moral hazard.
It is Heads!
The ‘economic package’ as proposed by the government under “Atmanirbhar Bharat Abhiyan” to fight the revenue losses during pandemic has brought in some reliefs for the MSME sector in its second phase. While unpacking the ‘economic package’, one can find several benefits for MSMEs across the country. The Finance Minister, Ms. Nirmala Sitharaman, announced a INR 3 lakh crore collateral free loans for MSMEs on 13 May 2020. The decision of the government to act as guarantors in case of unexpected credit loss is a cherry on the top. The tenure of such loans is 4 years and can be availed by owners of MSMEs till 31 October 2020. From imposing a 12-month moratorium on repayment to changing the definition of MSME, the government seems to have tried to help in every way possible. The new definition classifies MSMEs as per their turnover and not based on their business (manufacturing or services).
The government has taken all these efforts to support MSMEs whose accounts are standard with the trust that they were doing well before the COVID- 19 pandemic, and there is no reason why they cannot continue to do so if given some monetary help in difficult times. The resolution of the government to provide a credit guarantee was the best optimum solution to a unique problem. The banks had credit facilities but feared to lend any money due to high risk in such times and creating more ‘stressed’ assets. On the other hand, the government did not have an adequate amount of money to directly infuse into the market to boost the economy. Indian Banking Association had already informed that banks were ready to lend money to MSMEs and NBFCs provided government backs up as guarantors. Nevertheless, the government still has to incur an opportunity cost in terms of ‘moral hazard’.
The Issue of Moral Hazard
Moral hazard refers to the behaviour of a party engaged in excessive risk-taking wherein a third party is liable to pay the losses arising from such excessive risk taken.[1] Such an assurance by the risk bearer (third party) induces the risk- taker (first party) to engage in such risky business to reap large profits. The concept of moral hazard often occurs in the insurance sector. After taking insurance coverage on an automobile, the insured tends to engage in rash driving or reckless behaviour as the insurer undertakes the loss arising from such activity.
In the present context, the government’s intervention to revive the liquidity crunched MSME sector exacerbates the problem of moral hazard and leads to a catastrophic event for the banking institutions.
It has been observed that the behaviour of the market participants to take excessive risk arises when there is an incentive given to them in the very first place.[2] The implementation of the government- backed guarantee scheme incentivizes the banks to take excessive risk by indulging in an imprudent lending activity. The banks are aware of the government support in case any borrower defaults from its obligation, and the same induces them to engage in risky investments. In the normal practice, the banks are hesitant to engage in such a risky investment and carry out enhanced due-diligence before lending. However, this will not be the same in the case of a government-backed guarantee scheme. Hence, the issue of moral hazard intensifies because the banks are involved in excessive risk- taking practice and the cost of its potential loss is borne by the government.
Further, the initiative of the Indian government to provide liquidity for MSMEs exhibits similar traits of government-backed deposit insurance policy adopted by the U.S.A. The aftermath of the Great Depression led to the incorporation of Federal Deposit Insurance Corporation (FDIC) tasked with the responsibility of restoring public confidence by providing insurance coverage to the deposits received by the banks.[3] This lured the banks to engage in risky investments and irresponsible lending practices as they were aware of the guarantee provided to the depositors by the FDIC in case of any default by the banks. This has also been cited as a classical example of 'explicit moral hazard'.
One of the main reasons for the global financial crisis (2007-08) was excessive risk being taken by various market participants.[4] The financial crisis compelled the U.S.A. government to intervene to prevent the collapse of financial institutions.[5] Government intervention can be seen in the form of credit facility rendered to financial institutions, recapitalization, or implicit / explicit guarantees. The government intervention has raged the issue of moral hazard, and this was heavily criticized since the taxpayer’s money was utilized to revive the dying financial institution. This led to the enactment of the Dodd Frank Act to address the issue of government bailout and moral hazard.
Conclusion
The authors acknowledge and agree that the government’s intervention becomes the need of the hour to restore the lost public confidence. In such situations, it is often said that “if the price has to be paid for the survival of the system, so be it.”[6] However, should this mean that the economic harm caused by the problem of moral hazard be neglected? Are there no alternatives or measures which could be taken to reduce the risk of moral hazard? Indeed, there is!
One way of curbing the risk of moral hazard could be that the government should not provide a 100% guarantee to the lenders who are providing loans to MSMEs. The guarantors shall be partially liable. Also, there must be an oversight council or a watchdog to scrutinize the activities of banks which can sanction their lending activity and thus save the economy from another financial collapse.
[1] Marilyn Friedman, To Bail out or Not to Bail out: Moral Hazard and Other Ethical Considerations, 11 Geo. J.L. & Pub. Pol’y 411, 413 (2013).
[2] Kevin Dowd, Moral Hazard and the Financial Crisis, 29 Cato J. 141, 149 (2009).
[3] Elisa S. Kao, Moral Hazard during the Savings and Loan Crisis and the Financial Crisis of 2008-09: Implications for Reform and the Regulation of Systemic Risk through Disincentive Structures to Manage Firm Size and Interconnectedness, 67 N.Y.U. Ann. Surv. Am. L. 817, 821 (2012).
[4] Steven L. Schwarcz, Too Big to Fool: Moral Hazard, Bailouts, and Corporate Responsibility, 102 Minn. L. Rev. 761, 761-762 (2017).
[5] Franklin Allen, et. al. Moral Hazard and Government Guarantees in the Banking Industry, Journal of Financial Regulation. 1 (2015).
[6] Peter L. Bernstein, The Moral Hazard Economy, HARVARD BUSINESS REVIEW, June 04, 2020, https://hbr.org/2009/07/the-moral-hazard-economy.