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Change incentives instead of regulating outcomes

Deep insight from Eugene White in this paper (HT: Scott Sumner)

The fantastically costly failures of banks and other financial intermediaries are a consequence of appallingly bad choices made by managers. To gain unseemly executive compensation, managers had incentives to exploit conflicts of interests, increase leverage, and choose risky trades, instruments and portfolios. Reacting to these disastrous choices, policy makers have recommended splitting up the banks to make them smaller or limiting the scope of their activities. Elaborate efforts are being expended to ensure that leverage is controlled by raising capital and by gauging its exposure to the individual banks’ risks and systemic risk. Lastly, there have been calls for caps on executive compensation to reduce the rewards from risk-taking. These are very strong measures, but history suggests that they will not be lasting checks on risk. Previous reforms focused on regulating choices ultimately led to new institutions and instruments that circumvented the rules to take more risk.

Part of the recent crisis’ origins may be found in steady erosion of incentives that induced management to control risk. The problems of moral hazard from deposit insurance, “Too-Bigto-Fail,” and the “Greenspan Put” are well-known, though their magnitude is difficult to measure. In addition, the increasing ability of management to control the boards of directors has insulated them from efforts of rebellious shareholders to appoint new directors. Perhaps, the most important but least heralded change in the ten years prior to the 2008 crisis was the shift by most major investment banks from partnerships to limited liability corporations.

What is notable about contemporary reform is that there is little effort to change the incentives that caused bank executives to take the big risks and a huge emphasis on regulating their choices. The implicit assumption seems to be that incentives and the assignment of liability plays only a small role so that choices must be regulated—that is, the market cannot be made to adequately discipline banks. Could such a market-based system be devised? In this paper, I offer evidence from the American National Banking Era (1864-1913) for the ability of incentives to successfully limit losses from bank failures.

(Title up the post has been updated. HT to Paul Ramer.)