Moral Hazard - Management

Management

Moral hazard problems also occur in employment relationships. When a firm is unable to observe all actions taken by its employees, it may be impossible to achieve efficient behavior in the workplace: for example, workers' effort may be inefficiently low. This is called the principal–agent problem, which is one possible explanation for the existence of involuntary unemployment. Similar problems may also occur at the managerial level because owners of firms (shareholders) may be unable to observe the actions of a firm's managers, opening the door to careless or self-serving decision-making.

Moral hazard can occur when upper management is shielded from the consequences of poor decision making. This situation can occur in a variety of situations, such as the following:

• When a manager has a secure position and cannot be readily removed.
• When a manager is protected by someone higher in the corporate structure, such as in cases of nepotism or pet projects.
• When funding and/or managerial status for a project is independent of the project's success.
• When the failure of the project is of minimal overall consequence to the firm, regardless of the local impact on the managed division.
• When a manager may readily lay blame on an innocent subordinate.
• When there is no clear means of determining who is accountable for a given project. The software development industry has specifically identified this kind of risky behavior as a management anti-pattern, but it can occur in any field.
• When senior management has its own remuneration as its primary motivation for decision making (hitting short-term quarterly earnings targets or creating high medium term earnings, without due regard for the medium term effects on, or risks for the business so that large bonuses can be justified in the current periods). The shielding occurs because any eventual hit to earnings can most likely be explained away, and in the worst case, if an executive is terminated, usually the executive keeps the high salary and bonuses from years past.
• When a numbered company is used for construction projects as a subsidiary of a larger enterprise. An example is a numbered company is incorporated to construct a condominium in Vancouver. It is built to meet the minimum building code requirements, but is not designed for Vancouver's typical weather patterns (mild temperatures, lots of moisture). A few years later, the exterior cladding of the building is disintegrating with mold and rot. The numbered company that built it has no assets, so the condominium owners must suffer a large expense to rebuild it. In this scenario, the senior officers of the numbered company, and its shareholders used the protection of a numbered limited liability company to take higher risks in the design and construction. Unless the law and the regulators have some effective means to hold those responsible to account, moral hazard would be expected to continue to future building projects. In extreme cases, moral hazard can lead to or permit control fraud to occur, where actual illegal activities take place.