Moral hazard is a familiar economic concept in insurance markets. It refers to the reduced incentive a consumer has to avoid a risk if they’re insured against that risk.
It’s an important idea in much public policy making too. For example, the state insures people against unemployment and the associated loss of income. But if that income support is set too high, then the incentive to find a new job reduces.
Closer to home, public support for failing banks is rightly seen as introducing unacceptable moral hazard: hence the focus on resolution arrangements and ending “too big to fail”.
So, how does moral hazard apply to the protection which FSCS provides to consumers who lose out when regulated firms fail? Does FSCS protection encourage people to take risks they might not otherwise take? If so, what can be done to reduce moral hazard?
These are not new questions but they are important.
I am, frankly, sceptical that FSCS protection carries a serious moral hazard. Here’s why.
Consider what conditions would have to be fulfilled for such a risk to exist? For one thing people would have to buy risky financial products which they might not otherwise consider because they are aware of FSCS protection. And, second, the consequences of embracing risk in this way would have to outweigh the adverse consequences to financial stability of curtailing FSCS protection.
It is very hard to see that the first condition is met.
The great majority of consumers simply lack either the interest or necessary knowledge to form a view about where financial providers lie on the scale of risk.
The banking crisis of 2007/08 provides a good illustration of this. It’s perhaps arguable consumers should have appreciated the high interest rates available from some of the failed banks were too good to be true. However, this assumes consumers are able to distinguish between risky behaviour driven by the need for short-term borrowing from competitive behaviour driven by building market share.
What is more, some banks failed because they were running business model relying on short-term borrowing in wholesale markets to lend long – which not even the authorities understood was unduly risky until those wholesale markets froze. What hope for the consumer?
So, in short, it is, in my view, unrealistic to expect consumers to undertake due diligence on the business models of high street firms like banks and building societies.
What’s more it is far from clear it would make sense to transfer significant risk back to consumers even if you took the view that some consumers were actively embracing higher risk because of FSCS protection. That is because exposing all consumers to risk would compromise FSCS’ ability to protect financial stability and harm consumer confidence. It would become rational for consumers to pull money from a bank or building society perceived to be in difficulty and, in doing so, to worsen a liquidity and confidence crisis.
This is exactly what we saw when Northern Rock got into difficulty in 2007. FSCS protection was much more modest than now – only £31,700 and left consumers exposed to losses because FSCS protected 100% of the first £2 000 and only 90% of the next £33,000. No doubt this was not the only factor, but we all saw the result: queues in the street.
The concern about moral hazard is, to my mind, even harder to justify when it comes to the provision of regulated advice.
Generally, consumers seek advice to reduce risk, not to embrace it. They know the limitations of their knowledge of financial matters and of product markets. Indeed, we positively want to see the advice market expand to meet the need for advice as consumers increasingly take advantage of the Government’s liberalisation of retirement savings.
So it is very important that consumers who do the right thing and who get independent advice from a regulated intermediary are protected if that advice turns out to be wholly inappropriate to their objectives, circumstances and attitude to risk.
And just to reiterate FSCS will only provide that protection where a Court would have concluded that a civil liability existed on the part of a solvent firm. We do not second guess advisers’ judgements. We do not protect people from ordinary investment risk where appropriate investments perform less well than expected.
But we do, of course, take into account the claimant’s own level of knowledge and sophistication, as well as what they are told by the adviser. We would not, typically, conclude a civil liability existed where an investor well understood the risks they were taking in adopting a course of action proposed by an adviser.
In short, I see little or no evidence that FSCS protection is encouraging people to take risks in the investment field they would not otherwise take. I do, unfortunately, see too many examples of people induced to take inappropriate risks because of bad advice. FSCS rightly protects those people.