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Incentives and the Financial Crisis

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Incentives and the Financial Crisis

A finance professor argues that preventing financial crises means creating policies that align bankers' incentives with the public interest.

In any financial crisis, it is possible with 20/20 hindsight to identify the specific proximal causes. Armed with this knowledge, legislators are invariably tempted to outlaw specific activities. After all, if these activities had been illegal prior to the crisis, surely the crisis would have been avoided. The flaw with this seemingly plausible logic is that it ignores the incentives that affect people's behavior. A better approach is to design legislation that better aligns the incentives of bankers with the public interest.

Bankers are incentivized to make money. Inevitably, their actions expose the economy to the kind of breakdown we saw in October. With new regulations on their behavior, future crises will no doubt look different, but they will not be eliminated. The only way to avert crises is to treat banking in the same way we treat polluters: Create an environment that internalizes the negative externalities banking activity generates. That is, we should give bankers incentives so that they do not want to engage in the kind of risk taking that exposes the whole economy to a meltdown.

To address this, we need to examine the effect of leverage. When investors invest borrowed resources, a problem known to financial economists as "asset substitution" is created: If the investment goes bad, the investor can declare bankruptcy and leave the debt holders bearing the costs. Because of this downside protection, risk takers have an incentive to take on more risk than they would if there was no leverage. Most debt holders are well aware of these incentives, and ordinarily they monitor the behavior of the risk takers with policies like margin requirements. By doing so, they avoid exposing themselves to unduly large losses and lessen the likelihood of a larger financial meltdown. But when the government implicitly insures debt holders by bailing them out in bad times, the incentive to monitor borrowers is reduced. The inevitable consequence will be much larger and more costly crises in the future.

Government action might well be required to address this problem. But it would be a big mistake for legislators to focus on regulating leverage, the activity perceived to have caused the current crisis. Instead they need to concentrate on undoing the perverse incentives to take on risk that results from the perceived willingness of the government to bail out large risk takers. As matters stand right now, it is clear that once investment banks (or whatever these risk-taking entities will call themselves in the future) reach a certain size, they become too big to fail, and thus the entities that hold their liabilities know they can implicitly count on a government guarantee. Competitive debt markets will internalize the implications of this guarantee, and the result is that large investment banks will find that they can borrow at artificially low costs of capital, providing yet an additional incentive to take on more risk. Because smaller banks will not have this implicit guarantee, they will be at a competitive disadvantage in this highly competitive environment. The likely result is further consolidation of the industry and a compounding of the problem.

To avoid the mistakes of the past, legislators should begin by taking as given the incentives investment bankers and their lenders face. It is naïve to believe that it is possible to control these incentives by passing tough new laws regulating specific activity such as the amount of leverage. Such regulation would soon become archaic as investment bankers invent new financial products that could achieve the same results without running afoul of the regulations. Instead legislators should consider reorganizing the industry to better align its incentives with the public interest.

Although a full analysis of how this can be achieved will require time and data, there are two policies that I believe are worth considering. The first, which I have alluded to already, is curbing the size of investment banks. By keeping them small, failures can be allowed in times of crisis without endangering the entire economy. Consequently, government can credibly commit to not bail out these institutions. Debt holders will then have incentive to aggressively monitor these institutions, greatly reducing the likelihood of future financial crises.

A second approach would be to align incentives by reconsidering the corporate structure of investment banking. Less than 10 years ago Goldman Sachs was a partnership. If Goldman was still a partnership today, its partners would be personally liable for all of Goldman's losses. That is, it would not just be their current bonuses that would be on the line, but their entire personal wealth. Faced with the potential of personal financial devastation, it is extremely unlikely that the partners would have allowed the firm to get into its current financial straits. By reorganizing investment banks into partnerships, the likelihood of another financial meltdown would be reduced far more than, for example, through restrictive regulation on their borrowing and lending activities.

One might argue that reorganizing investment banks as partnerships would reduce their incentives to take on risk and thereby hobble their ability to grease the wheels of capitalism. Such an argument might be correct: The positive externalities investment banks provide by being willing to take on risk might well outweigh the negative externality of an occasional meltdown. But it is worth pointing out that for 130 years Goldman Sachs operated as a highly successful and very profitable partnership. If those enormous profits are indicative of the value created in those years, one would be hard pressed to argue that the partnership structure handicapped Goldman's ability to take on risk or otherwise serve as a valuable middleman.

I believe it is naïve to believe that we can protect ourselves from future crises by simply passing tougher regulations. The political will to make structural changes will likely evaporate once the crisis passes. So although the window of opportunity to make structural changes is short, it would be a mistake to rush to legislative action. Congress should carefully consider how to align the incentives of risk takers before taking legislative action.

Jonathan Berk is the A.P. Giannini Professor of Banking and Finance

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