Tuesday, November 4, 2008

Not market failure, but ownership failure!

Chris Dillow feels that the ongoing financial crisis is an indictment of traditional capitalist ownership structures than free markets. He outlines four reasons

1. Principal-agent issues led to information asymmetry and moral hazard problems between chief executives (and investors) and traders.
2. When shareholding is dispersed, managers have no incentive to be prudent in their financial management (minimizing leverage etc) and no individual shareholder has much incentive to rein in management.
3. 'Good' financial innovation - of the sort advocated by Robert Shiller - has been lacking because it’s very difficult for anyone to own its beneficial effects; it’s a public good. By contrast, the gains from 'bad' financial innovation - overly complex mortgage derivatives - are more appropriable. So we get more of it.
4. The complexity of the markets and the instruments makes it impossible for managers to know the exact nature and location of their risks.

We can add a few more. Traders and fund managers have an incentive in camouflaging and dispersing risks, so as to maximize leverage and thereby magnify the returns. Further, while they made handsome profits when the markets were rising, there were limited sanctions in case of a failure, a sure-shot recipe for excessive risk-taking. Also there are numerous conflicts of interests arising from the functionally inter-twined nature of the big financial institutions. The moral hazard inherent in a firm architecture where its analyst is supposed to offer dispassionate reports on both the buy and sell side, while at the same time the firms' fund manager competes to get business from the same company whose shares are listed on the sell side by the analyst, are only too clear. Similarly, the rating agencies who are paid hefty rating fees by the Wall Street firms to assess their derivative offerings, have an obvious interest in keeping their paymasters happy. As also are the evident conflicts of interest between analysts and traders in the same firm.

Dillow suggests that the solution is not more nationalization, but creation of more vibrant internal markets. He advocates that the principals should become more like venture capitalists, allocating capital to semi-independent divisions, which put in their own capital. This would restrain traders’ risk-taking, as they can not so easily hide behind the fact that losses are spread over the whole firm. it is in this context that the research of people like Robert Shiller who proposes the introduction of markets in livelihood insurance, so that people can buy protection against job losses, and better markets in house-price futures, so we can insure against falling house prices, assumes great importance.

Dillow also highlights the relative lack of failures (though this is now changing fast) in the initial stages of the sub-prime crisis, among hedge funds. While publicly listed, dispersed share holding financial institutions have fallen like nine pins, private partnerships like hedge funds and private equity firms managed to at least survive the first onslaught.

In hedge funds, ownership and control are closely aligned, and most often hedge fund managers invest their own money and take key decisions themselves, or at least closely watch those who do. Their incentives to take huge risks have been smaller, and this partly explains the relatively limited leverage they have taken on. In stock market quoted firms, ownership and control are widely dispersed, thereby stoking moral hazard concerns. As the numerous failed examples show, ownership incentives like share options, are no guarantee against this.

Update 1
Daniel Kahneman draws the distinction between the objectives of firms and their managers, "There is a huge gulf between the companies and their agents. Firms take the long view, while agents have short perspectives and take the short view. The compensation models of the corporation and their agents are different. The executives did not commit suicide when they took risks; it was the corporations managed by these agents that committed suicide... the assumption that a bank should be seen as a single, rational player is irrelevant. One must look at who is managing the bank - management that receives incentives to do things that are not connected to anybody's interests".

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