The “grexed is goodh” mentalityy is a regularf feature of financialz crises. But were the traders and bankers of the sub-primeg saga more greedy, arrogant and immoral than that of the 1980s? Not really, because greed and amorality in finankcial markets have been common throughout the ages. Teaching morality and values in business schools will not tame such behaviour, but changing the incentives that reward short-term profits and lead bankers and traders to take excessive risks will. The bankers and traders of the latest crisis responded rationally to compensation and bonus schemes that allowed them to assume a lot of leverage and ensured large bonuses, but that were almost guaranteed to bankrupt a large number of financial institutions in the end.
To avoid such excesses, it is not enough to rely on better regulation and supervision, for three reasons:
lSmgart and greedy bankers and traders will always find ways to circumvent new rules
lCEOs and boards of directors of financial firms—let alone regulators and supervisors—cannot effectively monitor the risks and behaviours of thousands of separate profit and loss (P&L) centres in a firm, as each trader and banker is a separate P&L with its own capital at risk
lCEOs and boards are themselves subject to major conflicts of interest, because they don’t represent the true interest of their firms’ ultimate shareholders
As a result, any reform of regulation and supervision will fail to control bubbles and excesses unless several other fundamental aspects of the financial system are changed.
First, compensation schemes must be radically altered through regulation, as banks will not do it themselves for fear of losing talented people to competitors. In particular, bonuses based on medium-term results of risky trades and investments must supplant bonuses based on short-term outcomes.
Second, repeal of the Glass-Steagall Act, which separated commercial and investment banking, was a mistake. The old model of private partnerships—in which partners had an incentive to monitor each other to avoid reckless investments—gave way to one of public companies aggressively competing with each other and with commercial banks to achieve ever rising profitability, which was achievable only with reckless levels of leverage.
Similarly, the move from a lending model of “originate and hold” to one of “originate and distribute” based on securitization led to a massive transfer of risk. No player but the last in the securitization chain was exposed to the ultimate credit risk; the rest simply raked in high fees and commissions.
Third, financial markets and financial firms have become a nexus of conflicts of interest that must be unwound. These conflicts are inbuilt, because firms that engage in commercial banking, investment banking, proprietary trading, market making and dealing, insurance, asset management, private equity, hedge-fund activities and other services are on every side of every deal (the recent case of Goldman Sachs was just the tip of the iceberg).
There are also massive agency problems in the financial system, because principals (such as shareholders) cannot properly monitor the actions of agents (CEOs, managers, traders, bankers) who pursue their own interest. Moreover, the problem is not just that long-term shareholders are shafted by greedy short-term agents; even the shareholders have agency problems. If financial institutions do not have enough capital, and shareholders don’t have enough of their own skin in the game, they will push CEOs and bankers to take on too much leverage and risks, because their own net worth is not at stake.
At the same time, there is a double agency problem, as the ultimate shareholders—individual shareholders—don’t directly control boards and CEOs. These shareholders are represented by institutional investors (pension funds, etc.) whose interests, agendas and cosy relationships often align them more closely with firms’ CEOs and managers. Thus, repeated financial crises are also the result of a failed system of corporate governance.
Fourth, greed cannot be controlled by any appeal to morality and values. Greed has to be controlled by fear of loss, which derives from knowledge that the reckless institutions and agents will not be bailed out. The systematic bailouts of the latest crisis—however necessary to avoid a global meltdown—worsened this moral hazard problem. Not only were “too-big-to-fail” financial institutions bailed out, but the distortion has become worse as these institutions have become—through financial sector consolidation—even bigger. If an institution is too big to fail, it is too big and should be broken up.
By-: Garvit Dave
No comments:
Post a Comment