CHAPTER

Institutional Background

financial firm is, among other things, an institution that employs the talents of a variety of different people, each with her own individual set of
talents and motivations. As the size of an institution grows, it becomes more
difficult to organize these talents and motivations to permit the achievement
of common goals. Even small financial firms, which minimize the complexity of interaction of individuals within the firm, must arrange relationships
with lenders, regulators, stockholders, and other stakeholders in the firms
results.
Since financial risk occurs in the context of this interaction between individuals with conflicting agendas, it should not be surprising that corporate
risk managers spend a good deal of time thinking about organizational behavior or that their discussions about mathematical models used to control
risk often focus on the organizational implications of these models. Indeed,
if you take a random sample of the conversations of senior risk managers
within a financial firm, you will find as many references to moral hazard,
adverse selection, and Ponzi scheme (terms dealing primarily with issues of
organizational conflict) as you will find references to delta, standard deviation, and stochastic volatility.
For an understanding of the institutional realities that constitute the
framework in which risk is managed, it is best to start with the concept of
moral hazard, which lies at the heart of these conflicts.

2.1

MORAL HAZARDINSIDERS AND OUTSIDERS

The following is a definition of moral hazard taken from Kotowitz (1989):

Moral hazard may be defined as actions of economic agents in
maximizing their own utility to the detriment of others, in situations where they do not bear the full consequences or, equivalently,