The moral hazard of bailing out scam victims

Earlier this year, bowing to pressure from media and advocacy groups, banks acted to help out victims of financial scams. As the New Zealand Herald reported in April:

Banks will be required to reimburse fraud victims up to $500,000 and introduce new rules to crack down on scammers in a suite of measures unveiled today.

The changes include new technology to identify risky or unusual transactions based on a customer’s banking history and the ability to freeze payments and suspect accounts.

The moves are in response to Government demands to improve customer protections or be regulated in the face of Kiwi victims losing hundreds of millions of dollars to scammers each year...

The New Zealand Banking Association says it is rolling out a package of new protections in line with international best practice, which will be in place by November.

However, by itself the reimbursement of fraud victims creates a problem that might actually result in there being more victims of fraud overall. That is because of what economists call moral hazard. Moral hazard arises when one of the parties to an agreement has an incentive, after the agreement is made, to act differently than they would have acted without the agreement. Importantly, the agreement doesn't have to be a formal contract. It can be an implicit understanding or expectation.

In this case, there is an implicit agreement between banks and their clients, that makes it clear that the bank will reimburse the client when the client is impacted by a financial scam. Without that implicit agreement, bank clients have a strong financial incentive to avoid being scammed. If they are scammed, they lose a lot of money. However, now that banks will bail them out, bank clients have less incentive to act carefully and avoid financial scams. Scammers may be more successful as a result, leading to more scam victims.

This is not to say that bank clients will be flagrantly imprudent with their money, only that at the margin, clients will act a little less cautiously. The moral hazard problem here is that the risky actions of the bank clients end up costing the banks money, in the case when the bank client is scammed and the bank needs to reimburse them. If banks couldn't do anything about the risk, they would be less inclined to take on depositors. If the risk turned out to be extreme, the market for bank deposits could fail entirely.

Fortunately, banks can respond to this increased moral hazard in various ways. The first way is through increased monitoring of their clients. Notice in the quote from the article above that banks will employ "new technology to identify risky or unusual transactions based on a customer’s banking history". By monitoring clients' transactions, banks can hopefully head off any scam activity. Banks could also use incentives to reward their clients for not being scammed. Perhaps they could pay slightly higher interest rates to those that pass occasional bank-delivered 'scam checks' (where the bank employs someone to test whether the client will fall for a scam). None of the banks are proposing this yet, but it is a solution that is open to them.

Overall, this change is likely to be positive for bank clients. However, with these new scam protections in place, people will be less careful. Banks will need to remain very vigilant, or the number of scam victims will increase.