Ethical risk in economics and banking refers to any economic operation in which ethical criteria have been ignored. In order to render our research manageable, we only deal with two ethical concerns that are found to be most basic and prevalent, namely “moral hazard” and “adverse selection”, as they relate to operations of the usury-free banking system in Iran.
The best way to measure ethical risk is to review outcomes of existing procedures. For example we know that ethical risks in banking are reflected in overdue claims of banks. In the present study we thus evaluate the extent of non-performing loans as a measure of ethical risk.
In banking operations, we normally associate adverse selection with misallocation of bank resources, and moral hazard is defined as the borrower not abiding by his contract with the bank regarding how he uses the loan. The latter typically leads to non-performing loans.
Our study discovers the highest degree of ethical risks amongst private banks and the lowest level of ethical risks amongst specialized public sector banks. Among the different facilities provided, interest free loans are found to have the least ethical risk.