Incentives are the Problem
Already, the panic of late 2008 is fading. The financial system was rescued from its own mismanagement and institutions deemed systemically significant were saved by shifting most of the risk on to taxpayers. What has emerged is an even worse financial system. The survivors are “too-big-and-interconnected-to-fail” financial giants. They are the winners not because they are the best, but because they are the best supported. Without radical changes, another crisis is certain. External supervision is not the answer. Incentives are the issue.
At the heart of the financial industry are highly leveraged businesses operating with minimal capital. Their central activity is creating and trading assets of uncertain value, while their liabilities are guaranteed by governments. This is a licence to gamble taxpayers’ money. Allowing institutions to be operated in the interests of shareholders, who supply a small percentage of their capital, is insane. Trying to align the interests of management with those of shareholders is even crazier. In a highly leveraged limited liability business, shareholders will rationally take excessive risks, since they enjoy all the upside but their downside is capped: they cannot lose more than their equity stake, however much the bank loses.
Some of the ways managers are rewarded – options, for example – are themselves a geared play on rewards to shareholders. So managers have an even bigger economic interest in “going for broke” or “betting the bank” than shareholders.
The unpleasant truth is that the incentive to behave in a risky way is, if anything, even bigger than it was before the crisis. Deleveraging is the starting point for a healthier financial system but it would work best if we also eliminated today’s huge fiscal incentives for borrowing.
A distillation of ideas presented by Martin Wolf, Financial Times, June 2009
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