Martin Wolf on the Reform of Incentives as Part of Financial Regulation

Wolf:>FT.com / Columnists / Martin Wolf – Reform of regulation has to start by altering incentives: At the heart of the financial industry are highly leveraged businesses. Their central activity is creating and trading assets of uncertain value, while their liabilities are, as we have been reminded, guaranteed by the state. This is a licence to gamble with taxpayers’ money. The mystery is that crises erupt so rarely….>[B]anks are special sorts of businesses: for them, debt is more than a means of doing business; it is their business. Thus limited liability is likely to have an exceptionally big impact on their behaviour…. 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. In contemporary banks, leverage of 30 to one is normal….>A solution seems evident: let creditors lose. Rational creditors would then charge a premium for lending to higher-risk operations, leading to lower levels of leverage. One objection is that creditors may be ill-informed about the risks being run by banks they are lending to. But there is a more forceful objection: many creditors are protected by insurance backed by governments. Such insurance is motivated by the importance of financial institutions as sources of credit, on the asset side, and suppliers of money, on the liability side. As a result, creditors have little interest in the quality of a bank’s assets or in its strategy. They appear to have lent to a bank. In reality, they have lent to the state…. [C]reditors are most at risk in a systemic crisis. But a systemic crisis is precisely when governments feel compelled to come to the rescue, as they did at the end of last year….>The well-known solution is to regulate such insured institutions very tightly. But an enormous part of what banks did in the early part of this decade – the off-balance-sheet vehicles, the derivatives and the “shadow banking system” itself – was to find a way round regulation….>Such a crisis is not only the result of a rational response to incentives. Folly and ignorance play a part. Nor do I believe that bubbles and crises can be eliminated from capitalism. Yet it is hard to believe that the risks being run by huge institutions had nothing to do with incentives…. Regulatory reform cannot end with incentives. But it has to start from incentives…There are three players relevant here: shareholders of banks, lenders to banks, and managers and traders of banks. Shareholders are already on the hook to some extent: they can lose their investment. Nevertheless, there is space for reform. The natural reform I would like to try–to see what happens–would be to make financial-institution stock into par-value stock. It would work like this: If you hold a share of a regulated bank, then in a crisis the bank can call on you for an additional capital investment of up to $X. As a condition of their licenses to do business, financial institutions would be required to have outstanding equity on such terms and conditions that they can always call for half their book net worth from their shareholders.Lenders are now largely off the hook in the event of a systemic crisis. (They are on the hook for a one-off collapse.) I think lenders need to stay off the hook in a systemic crisis–what you gain in ex ante caution you more than lose in the additional likelihood of bank runs.Managers and traders are, however, where I would focus most of my attention. I believe we need compensation reform: compensation schemes that make it a complete personal catastrophe for the CEO and all other employees if their bank fails. If managers and traders are, personally, wiped out–reduced in assets to their last two cars and their last four-bedroom house–if any financial institution they worked for goes bankrupt anytime in the next two years, then we have a chance of creating sufficient caution. Otherwise, I don’t see how we do it.

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