Arnold Kling  

Do Financial CEO's Have Enough Down Side?

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Morning Commentary... Lectures on Macroeconomics, No...

Megan McArdle says yes.


If all people cared about was avoiding the possibility of outright starvation, then Sweden would be a country of wild risk-takers and epic slackers. And indeed, on the margin, there are people who don't bother to invest anything in their lives once their most basic material needs are covered. But most of us care deeply about not failing, even though we are unlikely to actually die of want should that failure take place.

She is saying that financial CEO's care enough about not failing that we should not worry about the fact that they walk away with millions of dollars while taxpayers have billions of dollars of cleanup costs.

I do agree that at the margin financial CEO's are more ego-driven than money-driven. (You should immediately think that as a shareholder it would be nice to pay your CEO in pure ego-boost and keep more of the profits for yourself.) But for, say Richard Syron at Freddie Mac, the fear of failure can translate into a fear of losing market share during a subprime boom, so that you're mostly afraid of not getting into the market.

I look at this crisis as a mountain of regulatory arbitrage. The brightest financial minds focused on ways to pile risks onto banks without regulators being able to see it.

If we are going to have a regulated, guaranteed financial sector (such as banks with insured deposits), then that sort of behavior needs to be criminalized. I would suggest creating a statute that makes conspiracy to mislead bank regulators a crime punishable be long imprisonment. Define the terms in the statute in such a way so as to make prosecution easy--don't create standards of proof so difficult that a good lawyer can get a guilty defendant off. Such a statute would really, really, raise the risk of setting up schemes to privatize profits while socializing losses. I don't believe that the financial geniuses were sufficiently concerned about that.


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COMMENTS (17 to date)
Adam writes:

Arnold,

Your exactly right on the problem: "The brightest financial minds focused on ways to pile risks onto banks without regulators being able to see it." But your wrong on the solution. The solution is not the Road to Serfdom. Hayek warned us that planners always seek more power (e.g., vague but severe criminalization in this case) when their plans don't work. The problem is the plan--insured banking is a bad and futile plan. Insured banking will always result in eventual system-wide failures.

It's time to return to some form of free banking (see recent EconTalk podcast). A small step in that directio might be to restore full financial liability, rather than limited liability, for top corporate managers and major investors. Full liability would at least ensure that the responsible parties would go broke when the bank goes broke. Clearly, too, the liability should not end immediately when a manager decides to leave the firm or the major investor decides to divest.

Let's try to find methods of restoring the inherent incentives sound management rather than bringing entirely new uncertainties (such a criminal law) into the equation.

Best,

Adam

Nathan Smith writes:

re: "If we are going to have a regulated, guaranteed financial sector (such as banks with insured deposits), then that sort of behavior needs to be criminalized. I would suggest creating a statute that makes conspiracy to mislead bank regulators a crime punishable be long imprisonment. Define the terms in the statute in such a way so as to make prosecution easy--don't create standards of proof so difficult that a good lawyer can get a guilty defendant off."

I see BIG dangers in this. Part of the essence of a free society is that people know what the law is and law-abiding people are not afraid of government coercive action. "Conspiracy to mislead bank regulators" is too vague a crime. People could slip into it without knowing it. It would essentially give the government arbitrary power over a large chunk of the elite, which in turn could be abused to put down guys who wanted to use their money to finance causes President Obama (say) doesn't like. Like Vladimir Putin. Or FDR and the Mellon tax trial.

Chris writes:

Isn't there also an ownership problem? CEOs don't truly have a financial stake in the success of their companies long term.

Sure, they lose future earnings, but everything they have gotten so far is safe. Criminal prosecution is one term to insert personal risk into the process, but I would be concerned that this would be captured by political process.

I'm not certain of a real solution, but limited liabilty seems to have washed away a lot of the real risk in putting a business at long term risk for short term gain.

Arnold Kling writes:

Nathan,
Nobody forces you to be the CEO of a regulated financial institution. People who don't want to be subjected to prosecution that they might think of as arbitrary are welcome instead to work in the free market.

Yes, I expect this sort of law to produce severe risk aversion among regulated institutions and to make executives lose sleep over what they might be doing that could get them prosecuted. That's what I want to happen.

Executives who don't like it can choose instead to work for other firms, where the only downside of failure is that the taxpayers don't bail them out.

Philo writes:

Let me second Adam's comment. "Conspiracy to mislead" is too vague crime. The government regulatory system was not sensitive enough to catch the sort of risk-taking that led to the present financial crisis, and cannot be made adequate to catch all the dodges (many of which *cannot* be made *illegal*) that "the brightest financial minds" can throw at it. This reveals the unworkability of government guarantees for bank deposits.

tom writes:

Arnold, what does the world look like when you neuter all banks and tell all maverick CEOs go into other businesses?

Who will lose--insured bank depositors or insured bank borrowers?

How much will uninsured lenders be able to cannibalize the home loan market when insured banks and their CPA CEOs can't do anything aggressive? And then won't the government need to act to preserve the business and returns of the guaranteed banks so that depositors will keep depositing? Otherwise depositors could abandon the entire guaranted banking system. (Would that be bad?)

Jim Gannon writes:

Arnold,

I greatly value your insights on the current financial situation, but I have to agree with the other commenters that "Conspiracy to mislead" is too vague and too easy for prosecutors to abuse.

Not that I have any useful suggestions...

tom writes:

I think everyone is misunderstanding Arnold. He knows that the term is broad. He is saying that there need to be extremely strict limits on guaranteed banks. Criminal liability is a simple way to do that.

I think it is a dangerous and cynical way to go, because Arnold wants to use public anger to get Congress to impose this type of liability. I think he wants this liability for a different reason than the public will--I think he expects that the guaranteed banking sector will shrink in the longer term if it is forced to operate this way. Congress will not be thinking that.

That's why Arnold says "IF we are going to have a regulated, guaranteed financial sector", it needs to be subject to strict limits. The "IF" is the key. He doesn't care if we do have a guaranteed financial sector. But if we do, he wants its teeth pulled, balls snipped and wings clipped.

I think it's dangerous to play with Congress about something like this:

1. Congress will be excited about imposing that type of liability and will expand it to situations where its guarantee or support is more limited. (Automakers?)

2. Congress will instruct its guaranteed sector that Congressionally-preferred risks (low-income home ownership) are not risky and can and should be done.

3. Congress will be highly motivated to assure the success of its guaranteed institutions against non-insured competitors.

guthrie writes:

I love this line: '... schemes to privatize profits while socializing losses'... this concept really helps bring things into focus, at least for me. While I understand the civil-libertarian concern, I agree that it ought to be criminal somehow. Collectivist activity ought to be penalized, no matter where we find it, because it's usually a threat to the free market.

Dan Weber writes:

I do agree that at the margin financial CEO's are more ego-driven than money-driven.

The problem is that, as I see it, money is how they currently drive their egos.

If your company crashes while you manage to get a $150 million dollar parachute, that has to feel pretty damn good.

English Professor writes:

My question is, can such regulation / threats / penalties protect the financial system as a whole? As I understand it, when the Fed intervened in the case of Long Term Capital Management, it did so to prevent "systemic collapse." That was only 10 years ago. Now we have far greater government interventions to prevent the same thing. Is there some sort of regulation that can protect the financial system per se without stifling creativity? If the question sounds naive, I'm sorry, but I'm not an economist. Yet it seems to me that this is what people should be talking about. What would such regulation look like? Would higher capital requirements be enough? In his most recent EconTalk interview with Russ Roberts, Arnold suggested that credit default swaps have no "natural sellers," and (if I understood him correctly) they tended to make people believe that they had protected themselves from risk when they had not. The CDS merely masked the risk. If this is correct, isn't the CDS, by its very nature, a threat to the system? If the shorthand definition of a CDS is a sort of "insurance policy" for a financial instrument, then shouldn't they be regulated by requiring reserves, etc., as in other forms of insurance?

Once again, my only concern is how to protect the system. I don't recall anyone talking about a serious threat to the overall financial system in the 1970s or 1980s. Then came the 1990s. I seem to recall some fear of spillover from the Mexican crisis, and then from the Asian crisis; then came LTCM, and now we have the current situation. The new financial tools and the freeing of global capital seem to be overburdening the entire system. How do we protect THAT?

Michael writes:

Conspiracy to mislead bank regulators is very vague. I sense that Arnold doesn't exactly want this, but is instead suggesting there be fewer regulations to elude.

The Snob writes:

Pace Tom, I am not sure that we really want maverick CEOs running government-insured banks.

Along with the S&L crisis we have had two major banking crises in the space of 20 years. Maybe what the banks need are a lot more dull, risk-averse CEOs who get excited about 4% annual growth?

Compared to 15 years ago our banking sector is much more consolidated and "innovative." As a depositor, all I've gotten are more ATMs, online bill pay, and fees every time I walk past a branch. As a small-money checking-only customer I used to get a few bits of interest here and there but not in the past 5 years or so. Have they become far better institutions for some other class of depositors?

Matt C writes:

Me too, I don't think this is a good idea.

It was not that long ago that you compared Paulson to Mussolini. With a system like this, you'd end up with a Duce of Finance soon enough. I do not see that as a win for consumers. Only a win for those bankers in the inner circle.

I have seen a lot of talk lately in support of the government getting even stronger powers, with less restraints. Talk from smart, reasonably liberty minded people. It's distressing.

CRuss writes:

I'm really surprised and happy to see you make a commennt such as:

"The brightest financial minds focused on ways to pile risks onto banks without regulators being able to see it. If we are going to have a regulated, guaranteed financial sector (such as banks with insured deposits), then that sort of behavior needs to be criminalized."

I've felt that way for a long time, well before the current financial crisis. It's all about incentives and accountability. Incentives to game the system are there, but serious downside accountability is missing.

As for such a law necessarily being fuzzy, so be it. Remember the designer drugs? A chemist would alter one molecule of an illegal drug and the resultant drug, though identical in effect to the illegal drug, would be legal in the eyes of the law. In 1986, a new law was passed making illegal any chemical "substantially similar" to an illegal drug.

If a rating agency employee knows intentionally slapping "AAA" on a debt instrument when it's undeserving might lead to prison, he'll perhaps refrain from such behavior. If not and he winds up in prison, the guy who replaces him will refrain.

It's been obvious for a long time that our markets were out of control. No one dared address the issue until the wheels fell off the financial system. It's amusing now to see the hand-wringing and calls for transparency and accountability. The power elite become antsy when the general public catches on.

Tracy W writes:

The brightest financial minds focused on ways to pile risks onto banks without regulators being able to see it.

Why weren't there any brightest financial minds focusing on ways to protect their clients from the risks being piled on the banks? I mean, the main losers from piling risks onto a bank should be the banks' shareholders, not the regulators. Shareholders are the ones who should be worrying about outwitting the sharks, not regulators.

don't create standards of proof so difficult that a good lawyer can get a guilty defendant off.

This means creating standards of proof so easy that a good lawyer can fail to get an innocent defendant off.

I think a wiser option would be to require any government-guaranteed banks to be partnerships with a limited number of people as partners. Partners have more of an incentive to avoid risk being piled on them than regulators do.

Snowfox writes:

In the middles ages charlatans were put to death when caught in the act of defrauding the crowds, yet in 2008 we reward them with millions of dollars. I worked as a consultant at both Fannie and Freddie I started to think that something was wrong wrong with me, that maybe I am stupid since nothing added up correctly. The second I raised my concerns I was let go. Yet to be fair, I cant say that every single persont that works there is irresponsible and corrupt but what I can say is both institutions have a cultures of corruption embedded in them that caused this meltown.
People went along with it since nobody wanted to look like an imbecile in front of others when derivatives and hedging were discussed, instruments used to game the system and the few who raised questions were socially quarantined as non team players, not smart enough to understand the business or the mechanics behind these complicated transactions which were suppose to spread the risk.
Sure, spread the risk so that tax payers end up paying for their pyramid schemes.
If you wear a mask and hold a gun and rob someone you go to jail for life. Yet when people in suits do it, they get compensated with milions of dollars..

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