The erosion in market discipline distorts market behavior and can give firms an incentive to grow

From Real Time Economics:

"By Phil Izzo

In a speech today before community bankers, Federal Reserve Chairman Ben Bernanke didn’t address the furor over AIG bonuses directly. However, he did speak to “unpleasant” choices that the government has had to make in rescuing financial firms. Bernanke has spoken previously about his angry reaction to the necessity of the AIG bailout, saying on CBS’s “60 Minutes” that the issue led him to slam down the phone “more than a few times.” Here are some excerpts from his speech:

Many of you likely are frustrated, and rightfully so, by the impact that the financial crisis and economic downturn has had on your banks, as well as on the reputation of bankers more generally. You may well have built your reputations and institutions through responsible lending and community-focused operations, but nonetheless, you now find yourselves facing higher deposit insurance assessments and increasing public skepticism about the behavior of bankers–outcomes that you perceive were largely caused by the actions of larger financial institutions. Many of you managed your businesses prudently and shunned more exotic instruments and activities. And many of your customers–households and businesses–avoided excesses and are able to meet their financial commitments on a timely basis.

No doubt this frustration has been heightened by the problems caused by financial firms that are too big or too interconnected to fail. Indeed, the too-big-to-fail issue has emerged as an enormous problem, both for policymakers and for financial institutions generally. Creditors of a firm perceived as too big to fail have less incentive to monitor and restrict the firm’s risk-taking through adjustments to the price at which they lend money to the firm. If left unaddressed, this weakening of market discipline creates an unlevel playing field for smaller institutions, which may not be able to raise funds as cheaply, even if their individual risk profiles are better, or at least no worse, than those of their larger competitors. The erosion in market discipline distorts market behavior and can give firms an incentive to grow–either internally or through acquisitions–in order to be perceived as too big to fail.

Government rescues to prevent the failure of major financial institutions also have required large amounts of public resources. These actions have involved extremely unpleasant and difficult choices, but given the interconnected nature of our financial system and the potentially devastating effects on confidence, financial markets, and the broader economy that would likely arise from the disorderly failure of a major financial firm in the current environment, I do not think we have had a realistic alternative to preventing such failures.

…

Supervisors must pay close attention to compensation practices that can create mismatches between the rewards and risks borne by institutions or their managers. As the Federal Reserve and other banking agencies have noted, poorly designed compensation policies can create perverse incentives that can ultimately jeopardize the health of the banking organization. Management compensation policies should be aligned with the long-term prudential interests of the institution, be tied to the risks being borne by the organization, provide appropriate incentives for safe and sound behavior, and avoid short-term payments for transactions with long-term horizons."

Me:

• Don the libertarian Democrat wrote:

“The erosion in market discipline distorts market behavior and can give firms an incentive to grow–either internally or through acquisitions–in order to be perceived as too big to fail.”

It’s good to see that the implicit government guarantees are finally being addressed.