The Philippine banking sector has endured a series of internal control breaches, which include last year’s money-laundering case involving Rizal Commercial Banking Corp. (RCBC), last quarter’s technological hiccups in the operations of Banco de Oro (BDO) and Bank of the Philippine Islands (BPI), and last month’s internal fraud cases at UnionBank and Metrobank.
Amid these incidents, the Bangko Sentral ng Pilipinas (BSP) assures the public that the entire Philippine banking system remains resilient. In January 2016 the BSP released Circular 900, which states that financial institutions must adhere to policies and standards to properly manage operational risks. Proper identification and response mechanisms should be present to address business disruptions due to calamities and system failure, employee theft, hacking, internal fraud and so on.
With or without Circular 900, however, risks are always present in bank operations. This article will discuss some of the risks faced by banks and the suggested measures to address such risks.
Economic theory depicts organizations as principal-agent relationships. Familiar illustrations include employer (principal) and employee (agent), shareholders (principal) and corporate management (agent), markets (principal) and brokers (agent), voters (principal) and politicians (agents), and regulators (principal) and private firms (agent).
In a principal-agent model, there are two individuals: a principal and an agent. The latter is permitted to act on behalf of, or to make decisions that have an influence on, the former. This arrangement is a contract where the principal decides which duties the agent should execute, and then determines the agent’s compensation for services rendered. The agent performs these designated tasks either because the principal is facing time constraints or because these tasks involve some specific range of skills or abilities.
As the principal’s representative, the agent is expected to maintain similar goals. If the principal’s objective is to efficiently produce a good or service, then the agent’s actions must cohere with achieving this outcome, since such actions affect the principal’s benefit. Clearly, the principal has an explicit interest in motivating the agent to behave as desired.
The fundamental problem of principal-agent relationships could come from two sources. First, the principal and agent have incompatible goals, probably because both are self-interested individuals. Second, the principal has difficulties in validating the agent’s actions. The principal cannot confirm: 1) whether the agent is always performing his or her duties in agreement with the former’s best interest; 2) whether aspects of what the agent does are unreasonable for the principal to scrutinize; and 3) whether pursuits that are worthwhile to the principal are expensive for the agent.
In the banking context, a bank accepts deposits from savers so that it can lend funds to borrowers who presumably have more productive uses for such funds. A bank must have trustworthy employees who can thoroughly screen loan applications to check if borrowers meet certain criteria (e.g., character, capacity to pay, capital, collateral and conditions). The so-called adverse selection problem occurs when potential borrowers who are the most likely to produce undesirable (adverse) outcomes are the ones who most actively seek out loans and are most likely to be selected. For example, people with huge debt burdens due to gambling and other vices are likely to be active loan seekers since they have a dire need for money.
Bank employees should also manage moral hazard, which is the risk that borrowers might engage in activities that are undesirable (immoral) from the lender’s perspective because such activities make it less likely that loans will be repaid. For example, instead of investing loan proceeds in a profitable business venture, an unscrupulous borrower might just gamble the funds in a casino or use the funds to indulge in other vices. Thus, bank employees are tasked to monitor the borrowers’ activities to ensure that the loans will eventually be repaid.
Nevertheless, there is a huge problem if the employees themselves can no longer be trusted to do their work properly. A loan manager, for instance, might be enjoying a lifestyle so lavish that she values it more than her employer’s reputation and eventually ends up defrauding the bank to sustain her lifestyle.
So, what should be done? Others have proposed tough measures, like having resident BSP auditors empowered to constantly test the internal control systems of banks. Others have also suggested that bank officials must be subjected to lifestyle checks, and their private accounts must be opened to the Anti-Money Laundering Council (AMLC) for regular evaluation.
Although bank officials get to enjoy relatively high salaries, these payments do not necessarily make them immune to temptation. Would it be fair, though, to specifically target bankers, or should the same level of scrutiny be applied to other occupations in both the private and public sectors? After all, is the banking sector the only sector that needs to be kept trustworthy?
Indeed, these are tough questions.
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Abigail P. Dumalus and Ser Percival K. Peña-Reyes are, respectively, former and current faculty members of the Economics Department of Ateneo de Manila University. Ms. Dumalus is studying at the University of Aberdeen in Scotland.