The term moral hazard has been used extensively in the context of the credit crisis in regard to the consequences of bailing out banks and not exposing either shareholders or executives to the downsides of excessive risk taking.

But moral hazard does not necessarily imply immoral behaviour or fraud. Rather, the term is used by economists to describe inefficiencies that can occur when risks are displaced, rather than the ethics or morals of the involved parties. When a party is insulated from risk, it may behave differently than if it were fully exposed to that risk.

Moral hazard has become a major issue for executive pay packages. If an executive team is rewarded for the positive outcomes of good investments, but insulated from the negative consequences of investments that turn sour, then we may encourage excessive risk-taking.

Many company boards faced with the prospect of an economic downturn are being pressured to review their executive pay plans. In some cases change is justified. In others it is not.

It is important that boards, regulators and shareholders not over-react. Moral hazard is a manifestation of the owner-agency problem where professional managers manage the business on behalf of absentee owners. Since managers are not owners, they will behave in ways to maximise their own long-term interests, rather than the owners’ interests, unless the interests of managers are aligned with the long-term owners. Maximising short-term shareholder value is not the goal per se, but rather building sustainable shareholder value over the long-term.

Owners want managers to take risks with their capital, but they do not want incentives that encourage excessive risk-taking. It is thought that, without incentives, managers would not be willing to take the risks owners require as a condition of putting their capital to work in private enterprise. But, if we over-react to an economic slowdown that originated elsewhere, and insist that rewards and penalties be equally balanced, then we will be back where we started before we induced management to take risks on behalf of shareholders.

As hired labour, optimal management behaviour will occur if they do not suffer as full a downside as shareholders, and nor should they benefit as much from the upside in the recovery. That is why, in addressing the problem of moral hazard, these considerations suggest putting a portion of, but not all, executive pay at risk for sustainability of performance.

One way to address moral hazard in executive incentives is to avoid asymmetrical bonus systems that have a high upside with limited or no downside. The other way is to better align the financial interests of executives with the interests of long-term shareholders, not short-term speculators. These can be achieved through:

(1) Having the performance period for incentives match the period required to determine whether executive decisions were successful (i.e., long vesting periods for incentive awards), or

(2) Providing that a portion of earned incentives or equity is held back and subject to future risk if the strong performance that justified the reward is not sustained in future years.

Australian companies are relatively well positioned on both of these:

• Unlike many of their American counterparts that originated the world’s current economic problems, Australian companies commonly have long term equity-based incentive plans requiring defined performance standards to be measured and met over a period of 3 or more years for the vesting of equity in the company.
• While there has been a disconcerting trend to focus on short term performance lately, many companies now require that some part of the annual bonus be held over as shares, accessible only after some years.

But, while Australian company executive remuneration plans, including equity plans, are well managed and governed, there is more that can be done to mitigate moral hazard in incentive design and governance practices. While some or all of these are not appropriate for all companies, a few suggestions include:

1. Consider share ownership policies. These policies provide market penalties for management decisions that look good initially but ultimately prove unsuccessful. Only a few Australian companies have share ownership policies requiring executives to build and hold substantial ownership positions in company shares, but these include the well managed Australian banks.
2. Hold shares past retirement. Require executives to hold shares for some time after they depart. Unfortunately, most share ownership policies do not transcend employment, allowing executives who see trouble coming to quit and sell their company shares. In addition, Australian tax regulations penalise the executives of any company requiring shares provided under employee equity plans to be held past termination, and remain a barrier to a better remuneration governance system.
3. Restrict access to the gains on exercising options. Requiring executives to hold half of the net after-tax profit shares remaining after covering the option exercise price and taxes for one year after exercise is not onerous. It would function as a form of risk management if the executives exercised at a high point and the shares subsequently declined because of poor performance.
4. Pay part of the bonus in restricted shares. Some Australian companies, including the banks, already do this. If a company has a high proportion of annual bonus in its senior executive pay mix, it is reasonable to pay a portion of bonus in restricted shares that are only accessible some time later. That way, strong but unsustainable performance in the bonus year would entail a penalty in the form of a decline in restricted share value if performance subsequently falters.
5. Consider making executives earn their bonus twice. A portion of the annual cash bonus would be deferred in the form of a three-year long-term incentive, with ultimate payment ranging from 0-150% of the deferred amount based on cumulative three-year performance. The justification is that strong performance in the bonus year is not worth as much to shareholders if that strong performance is not sustained in future years.

None of these approaches requires additional government intervention or regulation. The government can best help by fixing current tax regulation. Otherwise, all that is required is a decision by the company’s board.

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