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B. Venkatesh

EXPERTS hold the opinion that the Reserve Bank of India's decision to allow Oriental Bank of Commerce (OBC) to acquire Global Trust Bank (GTB) raises the problem of moral hazard. What is moral hazard?

Suppose you buy insurance for your new TV set. The insurance company promises to pay you Rs 15,000 if your TV breaks down.

Consider this. You want to watch a football match on the TV on a rainy day. Not a problem except that you are worried that the lightning might affect your TV set. What would you do?

Chances are you will still watch the match. Why? You are confident that you can replace the TV because the insurance company will pay if your TV breaks down. Think about it. You may have chosen to switch off the TV if it were not insured.

Your risk behaviour has changed because you have an insurance contract. This change in risk behaviour is termed moral hazard. Prof Kenneth Arrow, a Nobel-prize winning economist, popularised this subject in his book Essays in the Theory of Risk-bearing.

How does the moral hazard problem arise because of OBC's acquisition of GTB? It is now widely known that GTB gave many risky loans. Most of these loans had turned bad, which would have made it difficult for GTB to repay its depositors. The proposed acquisition by OBC will ensure that GTB depositors will get their money in full. Experts claim that protecting GTB depositors sends wrong signals to other banks. Why?

This decision may lead other banks to think that they will be bailed out too if their loans turn bad. So, they may actively seek high-risk clients. After all, such clients pay higher interest rate. That is the moral hazard experts are talking about.

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