Martin Wolf diagnoses the present crisis as arising from an extraordinary growth of credit in the economy since the new millennium. This in turn led to important distortions in incentives and fundamental imbalances to creep into the economy. Wolf encapsulates the story so far thus: "financial innovation and an enthusiasm for risk-taking generate rapid increases in credit, which drive up asset prices, thereby justifying still more credit expansion and yet higher asset prices. Then comes a top to asset prices, panic selling, a credit freeze, mass insolvency and recession. An unregulated credit system, then, is inherently unstable and destabilising."
George Magnus of UBS had argued very early that the present crisis is a “Minsky moment”, “A collapse of debt structures and entities in the wake of asset price decay, the breakdown of ‘normal’ banking functions and the active intervention of central banks”.
The fundamental incentive distortions were
1. Very loose monetary policy after the collapse of the tech stocks bubble burst in 2000 meant that credit was chasing consumers.
2. The financial deregulation and securitisation of the most recent cycle encouraged an unusually wide circle of people to believe they would be winners, while somebody else would bear the risks and, ultimately, the costs.
3. Complexity of the latest products of financial innovation like structured asset backed securities (ABS), meant that risk could be hidden away. It also meant that, as Martin Wolf says, "gains could be privatized and losses socialized".
4. Moral hazard arising from the knowledge that in a rapidly integrating global financial markets, government could not allow financial institutions to fail, encouraged financial institutions to innovate their way irresponsibly to destruction. The "Greenspan put" and other actions of governments furthered this moral hazard.
5. Certain derivative instruments and trading strategies like short sales, presents the possibility of spectacular gains with small investments. This potential for high return encourages investors to discount the downside probability of unlimited losses.
6. The huge surpluses built up by the Asian, East European and Oil exporting economies, lubricated the credit engines at little cost. American consumers could finance their spending binge by easy credit from Asian foreign exchange surpluses.
7. Inherent conflict of interest in large financial institutions. The central conflict is between the employees (above all, management) and everybody else. By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks and other financial institutions create gigantic incentives to disguise risk-taking as value-creation.
Martin Wolf argues that one way of preventing these incentive distortions from running amuck in the financial markets is to restructure the pay of bankers and fund managers. In order to align their incentives with the sustainable and long term health of the system, their pay should be "made in restricted stock redeemable over a run of years (ideally, as many as 10)". All bonuses and a portion of salary for top managers should be paid in restricted stock, redeemable in instalments. And since individual institutions will not do this on their own, regulators will need to step in.
In a FT column, Bankers’ pay is deeply flawed, Raghuram Rajan argues that the true merit of fund managers and bankers can only be judged from their alphas, which in turn can be evaluated only from their long run performance. But as the events of the recent past have shown, products of complex financial engineering, which take advantage of the ignorance and weaknesses of investors, appear to create high alphas. This illusion is engendered by the hidden tail risks taken, which produce a steady positive return most of the time as compensation for a rare, very negative, return. In reality these returns are betas dressed up as alphas.
Raghu Rajan's prescription for eliminating such distortions are, "Compensation structures that reward managers annually for profits, but do not claw these rewards back when losses materialise, encourage the creation of fake alpha. Significant portions of compensation should be held in escrow to be paid only long after the activities that generated that compensation occur."
Update 1
NYT editorial excoriates how the ongoing bailout socializes the costs of private bests gone bad. It writes, "Bear Stearns isn’t enormous. It doesn’t take deposits from the public. Yet the Fed believed that letting it implode could unleash a domino effect among other banks, and the Fed provided a $30 billion guarantee for JPMorgan to snap it up. Compared to the cold shoulder given to struggling homeowners, the cash and attention lavished by the government on the nation’s financial titans provides telling insight into the priorities of the Bush administration."
It calls for restructuring the incentives facing bankers, "But if the objective is to encourage prudent banking and keep Wall Street’s wizards from periodically driving financial markets over the cliff, it is imperative to devise a remuneration system for bankers that puts more of their skin in the game."
It brilliantly sums up the situation facing bankers, "Bankers operate under a system that provides stellar rewards when the investment strategies do well yet puts a floor on their losses when they go bad. They might have to forgo a bonus if investments turn sour. They might even be fired. Their equity might become worthless — or not, if the Fed feels it must step in. But as a rule, they won’t have to return the money they made in the good days when they were making all the crazy bets that eventually took their banks down."
It too suggests making bankers remuneration contingent on the performance of their investments over several years — releasing their compensation gradually. It asserts that "until bankers face a real risk of losing their shirts, they will continue blithely ratcheting up the risks to collect the rewards while letting the rest of us carry the bag when their punts go bad".
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