if one actually reads accounts of the decision making in the years leading up to the crisis, such as Gillian Tett’s Fool’s Gold and William D. Cohan’s House of Cards, no decision makers factored bailouts into their calculations. Why? Because they didn’t think they were doing anything particularly risky (an ignorance-based human error), so they didn’t even consider the chances of being bailed out.
Hmmm. Not the best evidence. Do you really expect Jimmy Cayne, the CEO of Bear Stearns to tell a reporter that he threw away his firm’s money because he thought he’d get it back from taxpayers? But here’s what he does tell William Cohan:
The only people [who] are going to suffer are my heirs, not me. Because when you have a billion six and you lose a billion, you’re not exactly like crippled, right?
And then there’s this moment from Andrew Haldane, the Executive Director of Financial Stability of the Bank of England:
A few years ago, ahead of the present crisis, the Bank of England and the FSA commenced a series of seminars with financial firms, exploring their stress-testing practices. The first meeting of that group sticks in my mind. We had asked firms to tell us the sorts of stress which they routinely used for their stress-tests. A quick survey suggested these were very modest stresses. We asked why. Perhaps disaster myopia – disappointing, but perhaps unsurprising? Or network externalities – we understood how difficult these were to capture?
No. There was a much simpler explanation according to one of those present. There was absolutely no incentive for individuals or teams to run severe stress tests and show these to management. First, because if there were such a severe shock, they would very likely lose their bonus and possibly their jobs. Second, because in that event the authorities would have to step-in anyway to save a bank and others suffering a similar plight.
All of the other assembled bankers began subjecting their shoes to intense scrutiny. The unspoken words had been spoken. The officials in the room were aghast. Did banks not understand that the official sector would not underwrite banks mis-managing their risks?
Yet history now tells us that the unnamed banker was spot-on. His was a brilliant articulation of the internal and external incentive problem within banks. When the big one came, his bonus went and the government duly rode to the rescue.