Wednesday, January 13, 2010

Government Failure: Why Are Bankers Reckless?

A popular answer to the question above, based on political populism and inept moralism, is: because they're greedy. As an explanation it's as sophomoric as saying that airplanes crash because of the force of gravity, but apparently it gets some people elected.

University of Minnesota law professors Hill and Painter came with a better explanation based on sound economics: because of wrong incentives created by poorly designed government regulations. Here's what they propose:

Reckless decisions by bankers led to the financial crisis of 2008. It's often suggested that if bankers were stripped of their bonuses, had their salaries capped and were paid in stock that couldn't be cashed for several years, this would motivate them to act responsibly.

Not so, according to University of Minnesota law professors Claire Hill and Richard Painter. They say such measures miss the heart of the problem.

In a recent paper, Hill and Painter argue that bankers will act recklessly as long as the risks they take don't expose them personally to real financial hardship.

The bankers whose decisions led to the 2008 financial crisis did lose all their stock and stock options. But they kept everything else. Millions from other investments,
summer mansions, jets.

"Once five or ten million is squirreled away from firm creditors," Hill and Painter say, "the rest is funny money." To solve the problem, they propose two ways to make bankers personally liable for their banks' debts.

Bankers who earn over $3 million per year would be required to enter a partnership agreement with their bank. That means if the bank becomes unable to pay its debts, the banker is personally liable. ...

All of a banker's yearly income beyond $1 million would be paid in assessable stock. That means if the bank becomes unable to pay its debts, the banker must pay an amount equal to the value of all the stocks received. ...

"Bankers who profit enormously from their occupations in good times," Hill and Painter say, "should be prepared to share in the costs borne by the public when the risks they take do not pan out."


King said...

This is a very plausible explanation. Isn't it explained by a sharp negative second derivative on the utility of wealth function? I always remember learning that in grad school, but it's from Friedman and Savage in 1952 or thereabouts. Gambling a thousand dollars matters a lot to me, but to Gilbert Arenas for example it means a lot less. Is there something more to the story than this?

Pedro H. Albuquerque said...

Good point King, as an economic exercise it would be interesting to see how their proposal would affect absolute and relative risk aversion as a function of wealth and income.

phil said...

This falls under the category of "well, duh!" So academe finally catches on to what those of us actually in the markets have understood since ever. The bankers understand they're covered and love it. The rest of us understand and hate it. The problem, however, will not be solved by economists or studies. The problem is one of political will.

Until we get the public to stop chanting "four legs goo...", er, make that "business good; government bad", and allow real regulation (eg reinstitute Glass-Steagall, illuminate dark pools, enforce SHO against MMs, un-bribe Moody's et al, outlaw FINRA advertising, etc, etc, and, most of all, construct a firewall where the WS/DC revolving door now stands - you know, fix all the deregulatory damage of the past 30 years) the scam will continue. The Reagan Revolution created this mess; it will take a Reagan-like figure, and a populace willing to embrace him/her, to clean it up. Thus far, Obama doesn't look like he's got the stuff. We'll see.

Pedro H. Albuquerque said...

Phil, thanks for posting, but your argument, although popular these days, is simply wrong: economic crises were more frequent and more profound before the eighties.

Matthew J. Lulay said...

How do you feel about Banks that are deemed "to big to fail" being forced to create and contribute to their own "bailout fund?" In other words, these very large banks would be forced to set a certain amount of money into an account during profitable periods that would be used solely for the purpose of bailing themselves out if they got found themselves in trouble. It seems that this would create better incentives to conduct better business.

Pedro H. Albuquerque said...

Hi Matt, thanks for posting, I agree that, conditional on the notion that bailouts won't be ruled out by this administration, then this proposal could reduce some of the incentives problems (but not all). However, the devil is in the details. I may write about it in another post.

phil said...

@Pedro, re:economic crises were more frequent and more profound before the eighties.

Well, since you didn't choose to support that assertion with any facts (how could you?), I'll help you out. The current recession, in terms of net job losses, is the deepest since 1948-49, when we were still reconfiguring the economy from WWII. The previous recession (2001>) was the longest since WWII. The recession before that (1990>) was the 2nd longest since WWII, and the one before that (1981>) was the 3rd longest.

Well, maybe all that unemployment agony would have been worth it if we got some real growth in exchange, right? Nope, you lose on that count, too. Annualized real GDP/capita growth for the 28 year era of deregulation (1981-2008) was 1.9%. Same measure for the previous 28 years (1953-1980) was 2.1%. Same measure for the entire period of Depression-era regulation (1933-1980) was 3.1%.

It's pretty obvious you live in an ivory tower world where any theory, however sophistic, can find support, and where deregulation is, in theory, a good thing. Hill and Painter may very well have a solution, but where's the beef? Why should we try out yet another academic guess, when the last one failed so pitifully? I live in the markets, Pedro, where Glass-Steagall repeal, the explosion of dark pools, and on and on, have turned my workplace into the Moral Hazard Casino, where riverboat gamblers play heads-they-win, tails-we-lose with not only the taxpayer's money, but everybody's.

Get a real job and try to make it in a world where managers stuff their pockets and stiff shareholders, employees and clients alike. Ronald Reagan's fantasy world of deregulation was just that, a fantasy world. Deregulation bought us the Savings and Loan crash of the late '80s, LTCM in the '90s, Enron and friends in 2001, $140/bbl oil in 2007, and the Investment Banker's Dominos game of 2007-08. Big profits for the managers, with the risk taken by the rest of us, in every case. ...and I won't even mention 900% payday interest rates, 10,000% overdraft charges, and all those other granular insults (whoops, looks like I did ;-)). It's time for those of us left picking up the pieces to get real.

Pedro H. Albuquerque said...

Phil, please inform yourself with the data presented here:
I can guarantee you that you'll not convince many readers of this blog by using arguments based on absolute figures such as "net job losses" or by hand picking your samples.

ENNYMAN said...

Good discussion. But unless I missed it, I did not see a comment about the picture, which was also worth a thousand words.

TokyoTom said...

Pedro, you and Hill/Painter are onto something. Moral hazard, risk shifting and growing regulation in response all have their roots in regulatory interventions: creation of limited liability corporations, insurance of banks/investment-capital requirements, regulation of "public" cos. That than caveat emptor/investor, we have firms and government socializing risk.

In addiiotn to Hill-Painter ideas, rolling back deposit insurance and relaxing regulation for financial firms that are partnerships (owners have skin in the game) would be helpful.

More here:

athi cele said...

This would really help to solve the economic crisis out there. And it would teach people to be more responsible with the way they invest their money.