Franchising’s moral hazard

Franchising’s moral hazard

Moral hazard is a term used by economists to describe the greater likelihood that someone will take risks if they are subsequently not liable for those risks.

The term has been used by the insurance industry since the 17th century, but took on new life during the global financial crisis (GFC) as governments in major economies such as the United States and the United Kingdom bailed-out banks and large corporations who were at risk of collapse.

The GFC demonstrated that moral hazard exists when banks engaged in high-risk lending to uncreditworthy borrowers, then packaged-up and sold these risky loan portfolios as investments, which subsequently proved to be worthless. The government bailouts in the US and UK then transferred the consequences of the banks’ risky lending behaviours to the taxpayers of those countries. (Fortunately the banking sector in Australia did not require such extreme government intervention).

Insurers have historically used the concept of moral hazard to mitigate risk. By increasing premiums according to risk, and by requiring the payment of an excess whenever a claim is made, the insurer moves some of the risk back to the insured party. Without this partial assignment of risk, an insured party could behave with outright abandon in the knowledge that any consequences of their actions or neglect will be borne by the insurer.

So does moral hazard exist in franchising?

The answer is yes, and in more ways than one.

Franchisors are faced with moral hazard as their businesses depend on growth provided by the human and financial capital of franchisees. Start-up franchisors and those without any company-operated outlets are more prone to moral hazard as the consequences of their actions pose a greater risk to their franchisees, rather than themselves.

Such actions could involve the franchisor’s method of selecting franchisees, training and supporting them. Other actions involve the franchisor’s choice of location for a franchisee to operate, the business model itself, as well as marketing and supply chain economics.

On an individual and isolated basis, franchisees bear the primary risk of decisions made by franchisors.

However, the risk is eventually transferred to the franchisor if the franchisor’s decisions result in the failure of the majority or entire network, and the consequent loss of a viable income to the franchisor.

Unlike the banks during the GFC, governments don’t bail out franchisors in financial distress. The moral hazard for franchisors whose behaviours transfer all risk to franchisees is that the widespread failure of franchisees will ultimately have consequences for the franchisor.

Mature franchisors who see value in fewer but happier franchisees understand this better than enthusiastic newcomers whose sole focus is on building outlet numbers, regardless of individual outlet performance.

However, despite the obvious perspective of moral hazard applying to franchisors, it also applies to franchisees.

Franchisees invest in franchises rather than starting their own independent small business in order to mitigate risk. The moral hazard is that the business model in a franchise is fully developed, comprehensively proven and has such substantial market demand that the franchisee need only open their doors to commence trading and the customers will come pouring in.

The moral hazard here is the free-riding of the franchisee on the franchisor’s brand name and reputation, without additional local effort by the franchisee to ensure the success of their business. In other words, the franchisee contributes only their financial capital, but applies little or none of their human capital to the success of their business.

So if the business doesn’t work, the moral hazard of the franchisee is to attribute the failure to the franchisor, and seek redress accordingly.

The risk of additional outlets

A mutual form of moral hazard applies for multiple-unit franchisees.

A franchisor who grants additional outlets to an existing franchisee faces little risk themselves initially in doing so. The risk of the additional outlets is all borne by the franchisee as an increase of their capital invested in the franchise (usually through additional borrowings). The franchisee’s own human capital is already fully invested in the franchise at this stage anyway.

But moral hazard applies to the franchisee too. For each additional outlet granted to them by the franchisor, the franchisee transfers the risk of that decision to the franchisor as the franchisee becomes larger and dominates a particular market or region. Franchisors can’t afford for multi-unit franchisees of major size and market dominance to fail, for reasons of market share, prestige and so on.

(The franchisee can thus exert a level of influence over the franchisor akin to the tail wagging the dog, rather than the other way around.)

Moral hazard is poorly understood by non-economists outside banking and insurance industries, but is relevant to help understand the perspectives of both franchisors and franchisees.

The idea that someone else bears the consequences of risks undertaken by one party is the basis of moral hazard. This article has identified how moral hazard can apply to both franchisors and franchisees.

Bailouts unlikely for the franchise sector

However, the key difference between the moral hazards of the banking sector in the US and UK during the GFC and the franchise sector today is that governments are unlikely to ever offer bailouts to the franchise sector in the same way that bailouts have been offered in the banking sector.

Furthermore, governments have sought to reduce moral hazard in franchising through reducing information asymmetry (i.e. the extent to which one party has more information compared to another) to help potential franchisees better assess the risk of joining a franchise.  

Since 1998 in Australia the Franchising Code of Conduct has reduced the information asymmetry between franchisees and franchisors by requiring mandatory disclosure of around 270 items of information in relation to the franchise offer.

Several amendments to the Code over the years have further reduced this asymmetry, and next year when a new Franchising Code is introduced, the asymmetry will be reduced even more, plus potential franchisees will be given a risk statement to assess as part of their due diligence.

Moral hazard for franchisors will also be eroded next year under the new Code with the introduction of fines and penalties for breaches of the Franchising Code of Conduct.

This means that franchisors will bear greater risk for the consequences of their actions, though this increased risk will be via a third party (the Australian Competition and Consumer Commission as the agency responsible for enforcing the Franchising Code of Conduct) rather than via franchisees themselves.

With an updated version of the Code due to be released imminently by the Australian government, the sector will soon be able to evaluate franchising’s moral hazard going forward.

Jason Gehrke is the director of the Franchise Advisory Centre and has been involved in franchising for 20 years at franchisee, franchisor and advisor level.

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