Tag Archives: Banks

Quote of the Day

“One solution is giving back to bank creditors the job of policing bank risk-taking. Roll back deposit insurance, for instance. We may not be able to see the future, but we can incentivize caution as a general matter. And we can improve the odds that, when banks make mistakes, they won’t all make the same mistake at the same time.”

— Holman Jenkins, The Wall Street Journal, January 18, 2011

Black swans? Or black crows?

Nassim Taleb is moving along just fine with an elegant critique of banking’s misaligned incentives . . .

In fact, the incentive scheme commonly in place does the exact opposite of what an “incentive” system should be about: it encourages a certain class of risk-hiding and deferred blow-up. It is the reason banks have never made money in the history of banking, losing the equivalent of all their past profits periodically – while bankers strike it rich. Furthermore, it is that incentive scheme that got us in the current mess.

Take two bankers. The first is conservative. He produces one annual dollar of sound returns, with no risk of blow-up. The second looks no less conservative, but makes $2 by making complicated transactions that make a steady income, but are bound to blow up on occasion, losing everything made and more. So while the first banker might end up out of business, under competitive strains, the second is going to do a lot better for himself. Why? Because banking is not about true risks but perceived volatility of returns: you earn a stream of steady bonuses for seven or eight years, then when the losses take place, you are not asked to disburse anything. You might even start again, after blaming a “systemic crisis” or a “black swan” for your losses.

. . . But then, after showing how easy it is for bank management to capture short-term gains without worrying about long-term risks, Taleb concludes that 

This is prompting me to call for the nationalisation of the utility part of banking as the only solution in which society does not grant individuals free options to look after its risks.

It’s a big leap from misaligned incentives to only the government can run banks. Doesn’t the expert theoretician of the highly improbable Black Swan understand that highly centralized governments are most often the cause of devastating Black Swan events? The only difference being: we shouldn’t really even call them Black Swans in the case of government failure. These events are not uncommon or unpredictable. The inherent difficulty and high-frequency failure of highly centralized bureaucracies managing dynamic systems is so common and predictable, in fact, that we might call them Black Crows. 

We can do much better than nationalizing the banks. Boards should obviously reform compensation practices. Today’s shareholders have been mostly wiped out. The shareholders of the “next banks” won’t soon forget. But most crucially we should amend the wildly incoherent monetary policy regime that does more than any other private or government action to misalign incentives. During credit bubbles, dollars are easily vacuumed up by the financial industry. In a very real sense, they would be irresponsible not to exploit the Fed’s explicit free-lunch program of accommodation “for a considerable period.” Remember, Chairman Greenspan virtually ordered Wall Street to lever up.

A stable currency is the ultimate disciplinarian, the incentive aligner par excellence.

Update: See Taleb and Nobel psychologist/behavioral economist Daniel Kahneman discuss these topics at length here.

Mark to Mayhem

Brian Wesbury expands on a chief cause of the vortex that took down the U.S. financial sector.

Suspending mark-to-market accounting will not keep institutions that took excessive risk from failing. Bad loans are still bad loans and there is no way to avoid the pain that they cause. It will, however, end the negative feedback loop, which drags everyone down. It allows time to see if the wind shifts and keeps the flames from spreading.

In the 1980s, loan problems took down thousands of banks, but because we did not force fair value accounting, the economy and stock market actually thrived. Every money center bank would have been insolvent in the early 1980s if they were forced to write down Latin American debt to 10 cents on the dollar. Add in bad oil loans which took down Pen Sqaure and Continental and bad S&L loans, and it is easy to see that the bank problems in the early 1980s were much more severe than those of the 2000s. But the rules were not as inflexible as their are today. Problems did not spread, many banks eventually recovered their principle on Latin American debt and the economy grew.

In contrast, today’s problems are expanding, and have now caused the government to put almost $4 trillion of taxpayer funds at risk to support the financial system. This is an amazing sum of money, equaling 28% of GDP, or 42% of total US stock market capitalization, or more than a quarter of all household debt outstanding, or nearly 40% of all private household mortgage debt, or three times the amount of subprime loans outstanding at their peak.

The government has tried multiple strategies. The only thing they have in common is that they are designed to offset or stop the damage caused by mark-to-market accounting.