Reducing Moral Hazard in Finance

[Fifty]

Some folks think that the following aptly characterizes the incentive structure for people who make and manage investments in finance and banking:

Based on how their pay structure, they are incentivized to make a bunch of small gains while accumulating systemic risk, downplaying its importance because systemic collapse is, according to some Nobel economist, a 50 sigma event.

But then every few years one of those supposed 50 sigma events occurs, and a bunch of banks lose more than they ever made using such strategies, and bailouts and economic crises ensue (87 crash, S&L crisis, LCTM, 2008 collapses).

How might the incentive structure facing decision makers in finance and banking be altered so that these sorts of crashes are less likely? If your answer is to remove the notion of "too big to fail", realize that even if their employer was going belly up and wouldn't get bailed out, a lot of folks think that most of the relevant decision makers would have still ended up profiting off the whole thing given the structure of bonuses etc.

 

[The Yankee]

Making the major investment banks partnerships again might relieve the situation some. It would come at the cost of being able to raise capital through public offerings, however.

 

[Cutlass]

Make them use their own money to gamble.

 

[innonimatu]

Why, it's obvious, isn't it? The theory of efficient financial markets has been proven wrong, time and again. So, just nationalize finance and thus put an end to its use for the pure pursuit of profit.

 

[Perfection]

Perhaps it is possible to regulate banks in such a manner that disallows them to accumulate systematic risk?

This would of course involve a cat and mouse game between industries and regulators, but that's not really anything new in industry, is it?

 

[The Yankee]

Perhaps it is possible to regulate banks in such a manner that disallows them to accumulate systematic risk?

This would of course involve a cat and mouse game between industries and regulators, but that's not really anything new in industry, is it?

Innovation has produced so many new products and techniques so quickly that the regulators are ten steps behind, always.

 

[Fifty]

Making the major investment banks partnerships again might relieve the situation some. It would come at the cost of being able to raise capital through public offerings, however.

Is the idea behind that that as partnerships the decision makers would not be able to evade liability for the losses? Aren't there limited liability partnerships now that are almost as liability-free as corporations?

Make them use their own money to gamble.

What might be a principled way of making it illegal for finance and banking places to evade liability through incorporation and such, yet allowing other sectors of the economy to do it? I mean assuming you can't just categorically dismantle all the ways of making a business where the owner has limited liability, do you think anyone could come up with a way of implementing your idea that is lawyer-proof? By lawyer proof, I mean imagine a team of attorneys trying to figure out a way to give bankers limited liability while remaining within the letter of the law. Obviously you can't get specific, but I just don't even see generally how you might implement such a system.

 

[Fifty]

Perhaps it is possible to regulate banks in such a manner that disallows them to accumulate systematic risk?

I've read about those sorts of solutions, and the argument tends to be that as long as you let them go about investing, they'll figure out ways to accumulate systemic risk. The alternative is to make it illegal for them to invest, and reconstrue banks in a form modeled off of utility companies (provide a place to stuff your money, ATMs and cards and whatnot, in exchange for fees).

 

[The Yankee]

Is the idea behind that that as partnerships the decision makers would not be able to evade liability for the losses? Aren't there limited liability partnerships now that are almost as liability-free as corporations?

I mean a complete, private partnership. You don't do your homework, you not only lose your shirt, but the guy next to you also loses his shirt.

I cannot think of any moral or legal way to enforce this and I also do not think this would necessary be the wisest move by the largest banks.

Establishing reserve requirements, like for your standard commercial banks, may be a solution, although, as we have seen, there were plenty of ways to generate huge bets otherwise. See the subprime market, with the securitization.

There may be an argument for establishing a rule to force a lender to retain some percentage of the loans on its balance sheet.

 

[Fifty]

I mean a complete, private partnership. You don't do your homework, you not only lose your shirt, but the guy next to you also loses his shirt.

I cannot think of any moral or legal way to enforce this and I also do not think this would necessary be the wisest move by the largest banks.

Establishing reserve requirements, like for your standard commercial banks, may be a solution, although, as we have seen, there were plenty of ways to generate huge bets otherwise. See the subprime market, with the securitization.

There may be an argument for establishing a rule to force a lender to retain some percentage of the loans on its balance sheet.

Since a lot of the problems occur when Nobel economists misunderstand while simultaneously fetishizing fancy-looking math, might it be possible to just ban quant-style quantitative measures of risk? Like, equate using fancy pricing formulas with bad accounting practices, subject to criminal liability if discovered in an audit.

 

[Cutlass]

Is the idea behind that that as partnerships the decision makers would not be able to evade liability for the losses? Aren't there limited liability partnerships now that are almost as liability-free as corporations?

I'm not certain I remember the title correctly. But I think it's this book where the investment bank had a very strong culture of managing the risks that they took. Why? Because as a partnership, all the money that they were risking belonged to the owners. Then they became publicly traded, and that risk management culture was overwritten with a culture that paid no attention to risk. Hence they no longer exist.

What might be a principled way of making it illegal for finance and banking places to evade liability through incorporation and such, yet allowing other sectors of the economy to do it? I mean assuming you can't just categorically dismantle all the ways of making a business where the owner has limited liability, do you think anyone could come up with a way of implementing your idea that is lawyer-proof? By lawyer proof, I mean imagine a team of attorneys trying to figure out a way to give bankers limited liability while remaining within the letter of the law. Obviously you can't get specific, but I just don't even see generally how you might implement such a system.

In a partnership, the owners money is the managers money. In a traded company the managers are risking the money of people they never met. It is a fundamentally different mindset.

 

[Perfection]

Innovation has produced so many new products and techniques so quickly that the regulators are ten steps behind, always.

Maybe we need to restrain innovation to do this? Perhaps we would force companies to jump through a fair amount of hoops before releasing new products.

I've read about those sorts of solutions, and the argument tends to be that as long as you let them go about investing, they'll figure out ways to accumulate systemic risk. The alternative is to make it illegal for them to invest, and reconstrue banks in a form modeled off of utility companies (provide a place to stuff your money, ATMs and cards and whatnot, in exchange for fees).

Well we still need lenders. How could you get a loan in such a situation?

 

[Fifty]

Well we still need lenders. How could you get a loan in such a situation?

Maybe have banks do household lending, and make it profitable via the fee structure.

As for business lending, restrict that to separate entities like venture capital firms, with something vaguely like antitrust legislation to ensure that they can't get too big to fail (no idea how exactly you might accomplish that)

 

[The Yankee]

Maybe have banks do household lending, and make it profitable via the fee structure.

As for business lending, restrict that to separate entities like venture capital firms, with something vaguely like antitrust legislation to ensure that they can't get too big to fail (no idea how exactly you might accomplish that)

Was there anything in the Glass-Steagall Act that may be along the lines of what you're searching for?

 

[Cutlass]

Maybe have banks do household lending, and make it profitable via the fee structure.

As for business lending, restrict that to separate entities like venture capital firms, with something vaguely like antitrust legislation to ensure that they can't get too big to fail (no idea how exactly you might accomplish that)

Glass-Steagal.

edit: x-post

 

[Millman]

Then we have to live with the fact money gets wasted. That it belonged to police, teachers, roads, and other infrustructure and not a deficit.

Next time lets plan in advance how much we can spend.

 

[The Yankee]

Maybe we need to restrain innovation to do this? Perhaps we would force companies to jump through a fair amount of hoops before releasing new products.

How would you slice that pie? Many innovations are built on pre-existing accepted structures. Securitization of mortgages, for example, were only new in that someone thought to bundle those loans together and sell them as a unit. Credit default swaps, etc., are on the same idea.

Where would regulators begin? Where would legislation begin?

 

[Fifty]

Was there anything in the Glass-Steagall Act that may be along the lines of what you're searching for?

Glass-Steagal.

edit: x-post

Interesting! I guess, though, since lots of these sorts of problems cropped up before the repeal (S&L crisis, LTCM, etc.), it wasn't enough to stem the problems I'm talking about.

I guess I'm more intrigued by the concept of banning phony measures of risk than of compartmentalizing the finance industry.

 

[The Yankee]

Savings and loans and Long-Term Capital Management sound awfully quaint these days.

 

[Perfection]

How would you slice that pie? Many innovations are built on pre-existing accepted structures. Securitization of mortgages, for example, were only new in that someone thought to bundle those loans together and sell them as a unit. Credit default swaps, etc., are on the same idea.

Maybe we wouldn't allow the bundled selling of certain things?

Where would regulators begin? Where would legislation begin?

I dunno! I'm just brainstormin'!