Tuesday, May 19, 2009

I know bankers. They are not stupid; most of them are smart, and many of them are brilliant

From the Atlantic Business Channel:

May 18 2009, 9:09PM

A Failure of Capitalism (II)--Whom to Blame?

The tendency in the media and the Congress has been to blame the current depression on "stupid, greedy, and reckless" bankers. I believe that that is a mistake. I know bankers. They are not stupid; most of them are smart, and many of them are brilliant. If they are "greedy," it is largely so in the sense in which most Americans (most anyone, I imagine) could be called "greedy": they like money a lot. I read somewhere recently that bankers (a word I use loosely to cover financiers in general) derive their job satisfaction entirely from their monetary compensation, unlike other workers. But that is wrong. Rich bankers derive satisfaction not only from making a lot of money but also from a sense of outsmarting competitors, and in that respect they are not unlike highly paid athletes; in both cases the money the stars are paid do not merely enhance personal welfare, but also are indicators of relative performance. Money is a scorecard of success. Professors are different, it is true--but only in that their scorecard is different: for money income are substituted citations, pretigious appointments, honorary degrees, and prizes.

With "reckless" we get a little closer to the truth, which is that banking is an inherently risky activity. The basic reason is that bankers borrow most of their capital, then turn around and lend it, and cover their expenses and make a profit by lending at higher interest rate than they borrow--and the higher interest rate is generated by the bank's assuming a greater risk of default than the people who lend the bank its capital. Typically, banks borrow short term and lend long term, and by doing so they generate a spread because lending short is less risky than lending long and so short-term interest rates tend to be lower than long-term rates.

The taking of business risks implies a positive risk of bankruptcy. Bankers cannot be criticized for risking bankruptcy, because they couldn't survive in business otherwise; they would lose their capital to nonbank lenders willing to take risks, such as hedge funds.

In fact the bankers took too many risks from an overall economic standpoint, and that is the immediate cause of the economic hole we're in. They made too many risky loans, especially in real estate, and when the risks materialized the banks' assets, which included many real estate mortgages and securities backed by such mortgages, plunged in value. The banks found themselves undercapitalized and reduced their lending, which slowed economic activity, which began the downward spiral that we're in.

They were permitted and indeed encouraged to take risks that were too great from the standpoint of economic stability by the government itself, in two major respects. First, the regulatory controls that had once limited the amount of risk that banks could take, in recognition of the potentially catastrophic effects on economic stability of a collapse or near collapse of the banking industry, were gradually dismantled, beginning in the 1970s. Not completely dismantled, but enough dismantled to allow competition almost free rein to push the bankers toward taking more risks than were good for the nation's economic welfare.

And second, the Federal Reserve pushed interest rates too far down at the end of 2000 and kept them there longer than made economic sense. The results included a housing bubble, a credit bubble, the bursting of the bubbles, and the ensuing swoon of the banking industry--all of which I'll explain in the next blog in this series. "


Don the libertarian Democrat

Economic Crises go through various stages. In the first stage, the main actors claim the Stupidity Defense, Elmer Fudd Defense, Ostrich Defense, the Devil Made Me Do It Defense, the Incentives Are Irresistible Urges Defense,Complexity Defense, Etc. In other words, masters of the universe now proclaim their ignorance and ineptitude, having previously made huge salaries. In a sense, you can't blame them, because that's what their lawyers tell them to say. This follows from the fact that fraud looks a lot like stupidity when it's discovered. This was the main excuse given for the that more actors weren't prosecuted in the S & L crisis.

The second main cause of this crisis will turn out to be Fraud, Negligence, Fiduciary Mismanagement, and Collusion. Of course, this will take time, because it needs investigation and litigation to ferret it out. That is just beginning. I'm not worried, because I know that, just as in the S & L Crisis, there will be excellent investigative journalism that will expose this eventually. Of course, by then, the country will have moved on, just like after the S & L Crisis, and we'll be back in line for another huge financial crisis in the future. And don't worry, I'm keeping a record of these prosecutions and litigation. But, saying that Subprime Mortgages weren't dodgy from the beginning, as you seem to be saying, strains credulity.

The main cause will turn out to be the implicit and explicit government guarantees. The economic concept of Looting will help bridge the gap between this cause and the one mentioned above. It will turn out that the large banks and investment firms made such large and iffy investments because they expected to be bailed out by the government. This doesn't mean that they expected the severity of our current crisis. It means that they were confident that their lobbying had bought an insurance policy called "Too Big To Fail". This explanation takes a while to sink in, but it is now being advanced by others as well. This explains the size and severity of the crisis.

No one is claiming anything about bankers in general. There are thousands of smaller banks that are doing fine, and there is no a priori way to determine the amount of fraud and negligence. It needs to be investigated. There's no point, at the very beginning of investigating a financial crisis, to be defending bankers as a group, unless you feel the need to deflect investigation into their conduct.

Here are a couple of quotes. I've lots:

"Andrew G Haldane*
Executive Director for Financial Stability
Bank of England
13 February 2009


"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 mismanaging 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. The timeconsistency problem, and its associated negative consequences for risk management, was real ahead of crisis. Events since will have done nothing to lessen this problem, as successively larger waves of institutions have been supported by the authorities"


"U.S. Federal Reserve Bank of Richmond President Jeffrey Lacker said late Sunday that a more limited financial safety net would help stabilize the financial system.

“I believe that a strong case can be made that the financial safety net, especially those parts that were more implicit and perceived than explicit and written into laws, played a significant role in the accumulation of risks that ultimately led to the turmoil we are still experiencing,” he said in prepared remarks to a banking conference in China.

Lacker argued that the presence of a government safety net limits the incentive for too-big- to-fail institutions to prepare for liquidity disruptions, “thus increasing the likelihood of crises.”

Finally, just on the interest rate question, low interest can be dealt with in any number of ways. How's it being dealt with now?

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