Moral Hazard, Part I

The key issue being exposed in the entire CL Financial bailout is that of Moral Hazard.  What is moral hazard and how does it have a bearing on this bailout?

A society in which people operate without standing the consequences of their actions is on a downward spiral to social breakdown or worse.  We have all discussed the social breakdown of our country with our friends and families.  Ours is a nation which has not suffered natural disaster, epidemics or invasion from our enemies, so the source of the breakdown is the absence of consequence.  The concept and reality of consequence is the essence of responsible, mature behaviour.

Moral hazard describes a situation in which, as a matter of policy, people escape the adverse consequences of their actions.  The idea that responsible people can, as a matter of custom and practice, escape the consequences of their actions is of course immoral to most right-minded people.  If there are no consequences, there is no motivation to do the right thing, other than an individual’s own private morals.  We all know how weak a safeguard those can be.  The hazard comes from the fact that the absence of consequence can encourage irresponsible and anti-social behaviour.  Hence the term moral hazard.

A society’s morality is the foundation upon which its legal system is built.  Morals come first and legalities are secondary.  An important point to note, for those who seem fixed upon which laws may, or may not, have been broken in this episode.  The point here is that it is possible to cause a great deal of harm by irresponsible behaviour, without necessarily breaking the law.

The Central Bank’s Governor has spoken directly on these points –

  • 30th January, in describing the causes of the CLF problems – “excessive related-party transactions which carry significant contagion risks. I should note that the high level of concentration is not specifically prohibited by the present legislation. An aggressive high interest rate resource mobilization strategy to finance equally high risk investments, much of which are in illiquid assets (including real estate both in Trinidad and Tobago and abroad).”
  • 13th February – “Clico/CIB were isolated cases of an overly-aggressive and risky business model.”
  • 11th March, speaking on that occasion on the limits of our financial regulations – “Even with all these pieces in place, any licensee who is committed to exploiting loopholes, to taking excessive risks with policyholders’ and depositors’ funds, and to bending the system could go undetected for a while and in so doing could do a lot of damage.”

The State is funding the bailout of the CL Financial Group and CLF’s operating methods were extremely risky ones.

There is no doubt in my mind that the bailout was necessary to prevent a huge financial disaster.  It was a necessary evil that we use taxpayers’ funds to preserve investor confidence.  The question is whether we are capable of learning from these experiences.  The litmus test is to ask – ‘What is to be the fate of those directors, officers, auditors, actuaries and attorneys who presided over the entire house of cards?’

We the taxpayers are now committed to finding the money to fix this colossal fiasco, and that is despite the fact that we did not cause it.  That is moral hazard for you.  This fiasco is due to CLF’s adventurous directors and officers.  What is to be their contribution to cleaning up this disaster?  Are these directors and officers going to be allowed to continue as if nothing happened?   I am asking whether CLF’s directors and officers are going to be let off the hook completely.

We continue to hold aspirations for Caribbean leadership and our response at this time of crisis is instructive as to challenges facing our region.

SIDEBAR: The CL Financial dividend

I have not spent any time on the many calls for the Minister of Finance to resign, be prosecuted, be fired and so on.  To me, the issue is simply too obvious for words and that is all.  I agree with Minister Enill that our time is better spent on the ‘bigger picture’.

The timeline set out in last week’s column allows an insight into the conduct of CL Financial over the last few crucial months.

CL Financial was unable to pay the interest or capital due to its depositors.  CL Financial was also unable to pay the benefits to which its policyholders were entitled.  We are told that that was the background to their letter of 13th January requesting urgent financial assistance.  We have no reason to doubt that account of events.

We have also read that dividends were paid to CL Financial shareholders on 16th January.  As a shareholder, the Minister of Finance knew that those dividends were paid after CLF requested State assistance.  The MoU, which is the ‘rescue plan’ for this fiasco, was signed on 30th January.  Why was that document silent on the refund of those dividends?

This cannot be allowed to stand.  It goes to the heart of the major issue of the negative long-term impact of a lack of consequence.  This is really the bigger picture.

Did the Central Bank know that a dividend had been paid to CL Financial shareholders after the written request for assistance and before the signing of the MoU?  If the Central Bank knew, why were CLF shareholders allowed to keep hold of those dividends?  If the Central Bank did not know, why not?  Was the Central Bank operating with an incomplete and misleading set of instructions?  Or are we contemplating something far, far, worse?


Methanol Holdings Trinidad Limited

Last weeks’ column sought to say that 2 statements on this aspect of the bailout – one from the Governor of the Central Bank and the other from MHTL – were contradictory.  It has been pointed out to me that those statements are not necessarily contradictory and I now accept that as being correct.


Equity in the Bailout process

Apart from the directors and officers of CL Financial and members of the government, there are other aspects of moral hazard at the level of the private citizen.

It is already a matter of concern that profits and benefits have been privatized, while the costs and losses have been nationalised.  That is a shame.  But there is more, since CLICO and CIB always offered the best interest rates and everyone knows what that means.

More reward is only available to those who have an appetite for more risk.  Those people who invested in CLICO knew that a greater rate of return was being offered.  Why then are we bailing out adventurous investors on these terms?

There is an apparent discrepancy in the terms of the bailout and that variance is interesting, to say the least.  CLICO Investment Bank has been absorbed by FCB and depositors there have been offered a choice of reduced interest at FCB rates, or the $75,000 entitlement under the Deposit Insurance scheme.  In contrast, CLICO’s depositors and policyholders have had their position fully guaranteed.  CIB, being a bank, was better capitalised, better regulated and its depositors were insured.  In terms of those benchmarks, CLICO was an inferior investment vehicle, yet the State has offered full protection to CLICO investors and only partial satisfaction to those who invested in CIB, the stronger company.  In my view the playing field should be leveled so that both sets of investors are offered the more modest package of benefits.

To continue with this lop-sided bailout only adds to the moral hazard of this messy situation.

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