Discussion

Moral hazard represents the risks when the board of directors or partners enter into
contracts in bad faith or providing the misleading information about its properties, debits or
creditworthiness. Moreover, moral hazard also means the partners has a motivation to take the
risks in negatively attempt to realize the benefits before the settlement of the contract. Moral
hazards exist whenever two parties agree with each other and each party, in the contracts, has the
occasion to benefit from behaving against the rules and standards that are set out by the
contracts. Every time among the parties in the contracts does not suffer from the possible risk
consequences, the moral hazard will increase (Kenton, 2020). Moral hazard in the corporate
governance refers to a situation where the executives or employees of a company are
encouraging to take the excessive risks or engaging in unethical behavior because they do not
bear the full consequences of their actions. It arises when the individuals or entities are shielded
from the potential negative outcomes of their own decisions. Moral hazard typically arises when
there is a separation between ownership and control in the company. The board of directors, who
represent the management and decision-making to executives and managers may have the
different objectives and risk preferences than among themselves, which can lead to moral hazard.
Therefore, the board of directors plays a significant role in corporate governance in providing the
oversight, guidance, and accountability in the management, so the board of directors might help
in minimize the moral hazard and promote more responsible decision-making within the
organization.

Moral hazard had been linked in the economic crisis, because in among other things,
some of the individuals were creating the risks that will be led to the crisis that may not have the
interests sufficiently aligned with those put at the risks by their own actions. An example was
from a Securities and Exchange report in 2008 on ratings agencies, which focusing on the rating
agencies’ activities in rating subprime residential mortgage-backed securities (“RMBS”) and
collateralized debt obligations (“CDOs”) which are linked to the subprime residential mortgage-
backed securities. The purpose of the examinations was to develop an understanding of the
practices of the rating agencies with surrounding of the rating of RMBS and CDOs. The
challenging issue of when board of directors should look after the risks that can be stated in the
following formula which are the board of directors should actively look after a C & E area if the
sum of the following two is relatively high for that area which are the general risks to the
company and moral hazard in connection with leaving C & E for that area to the sole discretion
of senior management and board of directors. That was a moral hazard analysis identifies from
an incentive’s perspective, senior managers’ interests regarding a particular risk area might
deviate sufficiently from those of the company so that the board of directors should look after
what is otherwise regarded as an area of the moderate risk in the moral hazard (Jeffrey M.
Kaplan, 2009).

The Theory of Agency and Moral Hazard

Corporate governance is an important component of the current business

environment since it influences organisational behaviour and decision-making. It relates to a
collection of procedures and policies that guarantee the management is effectively under control
and accountable to shareholders and other stakeholders. However, the problem of moral hazard,
which can have negative effects for all parties involved, is an ongoing issues in corporate
governance. In this discussion, a theory relating to the moral hazard problem in corporate
governance will be examined, along with its causes, effects, and possible solutions.

The moral hazard problem in corporate governance can be clarified using the concept of
agency. This theory holds that shareholders (the principals) provide managers (the agents)
decision-making power and control over firm resources so they may act in their best interests
(Valentine, 2009). However, this delegation establishes a principal-agent relationship, which
raises the risk of moral hazard.

When agents have a motivation to act in a way that serves their own interests over those
of the principals, this is known as moral hazard. Moral hazard can take many different forms in
the context of corporate governance, including excessive risk-taking, misappropriation of
company's assets, and manipulating financial information (Arcot & Bruno, 2011). These
behaviours may result in monetary losses, damage to reputation, and a decrease in the
organization's long-term value. In addition, an organisation may unintentionally experience
moral hazard problems caused by the board of directors.

The agency theory is the foundation for the notion of how boards of directors might result
in moral hazard problems which investigates the connection between principals (shareholders)
and agents (directors and executives) within a corporate context. Moral hazard occurs in the
context of corporate governance and may have a negative impact on the business when boards of
directors acting as the shareholders' representatives, fail to act in the shareholders' best interests
and instead pursue their personal interests.

The remuneration structure adopted by boards of directors is one method in which it

might promote moral hazard. Directors often get compensation in the form of a mix of fixed fees
and performance-based rewards like stock options or bonuses. Although the goal of
performance-based compensation is to align directors' interests with those of shareholders, this
practise has the potential to lead to moral hazard problems. Directors may be motivated to
prioritise activities that increase the company's stock price in the near future, even if they are
detrimental to long-term value creation, if a significant proportion of their remuneration is based
on short-term financial achievement. In order to achieve short-term objectives and maximize
their own financial gains, this might result in excessive risk-taking, such as pursuing aggressive
growth plans or participating in dangerous financial practises.

In addition, moral hazard may be influenced by the nomination and composition of

boards of directors. Directors are frequently chosen by the management or current board
members, which may lead to conflicts of interest. If directors owe their jobs to management, they
may feel obligated and motivated to support management's actions, even if they are not in the
best interests of shareholders. This could lead to a lack of independent supervision and a failure
to hold management responsible for its conduct. Additionally, if board members have strong
connections to other businesses or outside interests, they could put their personal networks and
relationships ahead of their fiduciary responsibility to the firm they work for, which could
compromise their objectivity and independence.

The lack of accountability and oversight procedures within boards of directors could
cause moral hazard problems worse (Achim & Borlea, 2013). The role of boards is to supervise
management and make sure they operate in the best interests of shareholders. However, boards
may fail to recognise possible moral hazard situations if they lack the knowledge or
independence to review management actions critically. This may allow management to act in a
self-serving manner without the proper checks and balances, which would harming shareholders.
 Asymmetry in information between shareholders and directors might further increase the
risk of moral hazard (Achim & Borlea, 2013). Compared to individual shareholders, directors
often have access to greater information about the business's operations, financial results, and
strategic objectives. Directors may be able to take advantage of their position and participate in
actions that benefit them at the expense of shareholders due to this informational advantage. For
instance, directors could use their insider information to participate in insider trading or make
personal investments that go against the objectives of the company. Moral hazard may be made
more prevalent by a lack of transparency and disclosure requirements since it makes it harder for
shareholders to adequately oversee directors' behaviour.

Moral hazard has wide-ranging effects on corporate governance that might have negative
effects on all stakeholders. From a financial standpoint, moral hazard can result in resource
misallocation, ineffective investment decisions, and in severe circumstances, even bankruptcy.
The majority of these effects are encountered by shareholders in the form of decreases in stock
prices and lower investment value.

Moral hazard is also damaging businesses' reputations by eroding the public's trust in
companies (Achim & Borlea, 2013). Relationships with clients, suppliers, and other important
stakeholders may suffer as a result of this lack of trust. Additionally, it can result in more
stringent regulatory oversight, legal proceedings, and possible penalties. If moral hazard is not
controlled, the overall effectiveness and stability of the financial system may be affected.
 REFERENCES
Abdullah H., & Valentine N. (2009). Fundamental and Ethics Theories of Corporate Governance,
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Achim, M. V.; & Borlea, N. S. (2013). Corporate governance and business performances.
Modern approaches in the new economy. Germany: Lap Lambert Academic Publishing.

Arcot, Sridhar & Bruno, Valentina. (2009). Silence is Not Golden: Corporate Governance
Standards, Transparency and Performance. SSRN Electronic Journal.
10.2139/ssrn.1343446.

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