Preventing the Next Financial Crisis

We have weathered the worst of the financial crisis of 2008-9. Time for renewed optimism? Unfortunately not. The next financial crisis is already programmed. It’s somewhat like an earthquake in Southern California. We cannot predict exactly when it will happen, but we know that it will. Yet unlike earthquakes, financial crises are man-made. They need not happen. They happen because we allow them to happen. We could take many measures to reduce their frequency and depths, but we fail to do so.

What about Dodd-Frank? Won’t it help? To its credit, it contains many good ideas. For example,

• Financial firms with access to the Fed should not be allowed to speculate. (The “Volcker Rule” prohibits proprietary trading.)
• Financial firms that are too big to fail should be broken up by the financial risk council.
• Financial firms should have higher capital requirements.
• Compensation of executives in financial firms should be subject to claw back.
• Whistle blowers can collect bounties for turning in executives if the executives’ compensation was based on inaccurate accounting.

Some good ideas, like an industry rescue fund, died along the way. Other good ideas have been put forth in academic discussions and been by-and-large ignored. For example, there is the suggestion that financial firms should be primarily equity-funded instead of debt-funded, that deposit insurance premia should be risk based, and that firms should disclose much more information about their bets publicly on a daily basis (which all large financial firms already have readily available), so that traders can become aware of systemic correlations in bets.

However, there are two critical problems with all these reforms and ideas. First, meaningful reforms will never happen. This even applies to the provisions already in Dodd-Frank. They will be castrated long before they are implemented. Wall Street simply has too much influence in Washington to allow any meaningful reform. More likely, Dodd-Frank will end up just as another Full Employment Act of Financial Lobbyists (a phrase coined by Barth, Caprio, Levine) and a source of rich campaign donations for influential politicians. As a whole, Washington is corrupt. This is not necessarily because individual politicians are corrupt, but because politicians that are well-funded by lobbyists tend to win elections.

I would be shocked if the Volcker Rule actually came to be implemented and forced Goldman and others out of the proprietary trading business. (Can Goldman simply declare itself to be “private equity” to qualify for an exemption?) I would be shocked if the financial risk council were to break up firms that are too big to fail. (Under what scenario are Bank of America, JP Morgan Case, Citigroup, Wells Fargo, Goldman, and Morgan-Stanley not already too big to fail?) I would be shocked if the banks cannot get around higher capital requirements, maybe not on day one, but slowly over the years. I would be shocked if Wall Street did not find new ways to insure executives’ and traders’ compensation against claw back. (How much of the current torrent in trader compensation [incl. pensions] can really be clawed back in 5-10 years?)

Second, even if I am wrong and tough Dodd-Frank reforms with teeth are actually implemented, none of them addresses the root of the problem. Every single diagnosis (and thus every remedy plan), both in academia and outside, has missed the central and trivially simple point. The root of the problem is that everyone on Wall Street has the incentive to gamble, regardless of whether it is in society’s interest or not. This is not just the case at the top, where executives earn money for risk-taking, but also the case for the traders. Traders earn more money if they take more risk, less money if they take less risk. The root of the problem is really this simple.

We can disagree about how good or bad these gambles are. We can disagree about whether these gambles are ultimately in the interests of shareholders or not. And, if a reader is among the truly faithful, (s)he can even argue that permitting unlimited gambling happens to be in the interest of the overall economy. But there should be no arguing that it is in the interest of gamblers, who are paid if they win, to gamble, regardless of whether it is or is not in the interest of the economy. In the language of economics, this is an externality.

Our current economic regulations are not only neutral but outright perverse. If there is a bet that has a positive expected wealth effect on the equity in exchange for a chance of crashing the bank and with it the economy, then it is the fiduciary duty of executives to take this bet. It maximizes shareholder wealth. This duty increases even more if failed banks might be rescued by the government. (One way to accomplish high risk and raise systemic risk is for banks to lend one another 95% of their gambling capital. A lends B 95%, and B lends A 95%. If one goes bust, so will the other, and the system will collapse, forcing government intervention.)

The bet itself probably won’t be mortgages next time. It will be something else. Maybe emerging-market investments. Maybe a new financial derivative. Maybe something else, altogether. The next bet will be discovered by some enterprising traders and supported by management. It will make many of these individuals fabulously wealthy. It will last for a while, crescendo, and then crash the system. And the rest of us will end up paying, one way or the other. If we bail out the financial sector again, then we pay directly. If we do not, then we will have an economic depression, the likes of which we have not seen in a century. But, either way, we will pay.

It’s already beginning. Wall Street value-at-risk and compensation of traders are returning to stratospheric levels, sometimes even exceeding pre-crisis levels. Bankers are extolling the virtues of ROE maximization–which just so happens to reward higher leverage and more risk. They just can’t help themselves. There is just too much money involved.

It is easy to blame the individuals involved. After all, ultimately, one simple fact is enough to explain the root cause of the financial crisis: not a single perpetrator of the financial crisis is destitute today. Most have become fabulously rich. This includes such luminaries as the former executives of Bear Stearns, Lehman, Merrill, Fannie, Freddie, AIG, and legions of their financial traders and deal-makers. This fact alone is enough to understand why the financial crisis has happened. Economics works! If agents are rewarded for an activity, then there will be more of it. If agents are rewarded with billions of dollars, then there will be a lot more of it.

Did the executives and traders get rich because they had such great talents? Unlikely. Although it is true that some of them may have shifted the odds a little towards the right, the ultimate cause of their riches was the variance and not the mean of the bets. These individuals became rich because of the very same bets that, when they finally failed, caused the collapse of their firms and of our financial system. Yes, these individuals were hurt by the ultimate collapse. They would have ended up even richer if the gambles had paid off longer (and, with high the firms’ leverage, very handsomely so). But, with gambling as their main capabilities, they would have had nothing without gambling in the first place. And quitting at the right time in a doubling-up strategy is tough.

Andrei Shleifer has argued that these individuals believed in their gambles. This is probably true. But I disagree with him that this is the root cause. In my opinion, these beliefs are an inevitable outcome of the system. Over time, it’s the risk-takers that are winning gambles that rise to the top of financial firms. Gambles that pay off frequently and are highly levered but that have a small probability of catastrophe are particularly well-suited to escape all alarm signs. It is traders who took such gambles and won that will run their departments and ultimately the whole firm. Of course, they will tend to believe that their bets had low risk. Any cautious executive who had correctly believed that mortgages were too risky in 2004 would have been fired well before 2007. It was no accident that ex-traders were in charge in many Wall Street firms. It was natural selection.

What can society do? Ultimately, there is only one real cure. We need to reduce the risk-taking incentives on Wall Street. Importantly, limiting the general incentives is different from limiting the specifics of what firms can do. The financial firms have smart employees. If regulation goes into details with what is allowed and what is not, then the executives and lawyers in these firms (earning multimillion dollar salaries) will run circles around the regulators (earning $100,000/year, and hoping to be hired by these firms afterwards; most presidents of the Fed of NY have gone to work for Wall Street after their term was over). Sooner or later, some politicians and regulators that are supported by Wall Street will end up in charge, and they will defang existing regulations. (And it is sooner, rather than later. The nomination of Peter Diamond, a Nobel-prize winning economist, to the Fed Board has just been successfully blocked by Congress, partly for “lack of industry experience.” If this becomes a requirement, then the banking sector itself would primarily control banking regulation, a sure recipe for ineffective and self-serving regulation.) Asking the government to regulate details is like asking a narcoleptic to guard the store–no matter how well intended, it is ultimately hopeless.

It is my belief that if we do not attack the weed by the root, for every leaf that we cut, three new leaves will grow elsewhere. We need remedies that 1) are not easy to tinker with, once enacted, and 2) truly threaten the essential livelihood of the individuals (and not just the shareholders) when the firm takes on large risks.

If these are two important criteria, then there are different kinds of remedies that suggest themselves:

We should legislate that all financial firm employees have a fiduciary responsibility not only to maximize shareholder wealth, but also to control firm risk. In addition, they should have a fiduciary responsibility to the integrity of the financial system overall. Clearly, this will only matter for very large firms, as small firms cannot endanger it.

We should legislate that even if a firm goes bankrupt ten years later, we can recover all compensation (or better yet, all wealth) of the responsible individuals. This should apply to funds transferred to family and friends, too.

We should impose civil personal liability that is explicitly not allowed to be insurable. (We should however allow firms to cover legal defense costs–this is a matter of due process.) Right now, corporate failure punishes disproportionally the public shareholders, most of whom have no real ability to influence the decision-making of these firms. It was not the Lehman shareholders that ran Lehman into the ground–it was Fuld, his lieutenants, and his board. For the future, it needs to be the executives and “their” boards that need to be punished, not the shareholders.

We should weaken the business judgment rule that shelter the board and executives from “willful ignorance” liability.

However, my two criteria suggest an even more radical remedy. We should legislate criminal penalties on the board, executives, and traders for taking on risk, or allowing risk to be taken on, that endangers the firm and/or the financial system. The offense and penalty are easy to understand and difficult to circumvent. Prosecutors are more difficult to lobby and influence than regulators. Criminal liability of individuals in charge hurts exactly where it is supposed to hurt.

The end outcome should be that individuals who are responsible for and/or fail to prevent systemically important financial firms from going bust would indeed go to prison if their firms go bust. If the firm fails or needs to be bailed out, it is prima-facie evidence that a firm had taken on too much risk. Analogous to drunk driving, the crime is not failing (causing an accident). The crime is getting into a situation in which failure can happen (driving drunk).

Is it unfair? I would argue that it is no more unfair than criminalizing other voluntary choices. Why is endangering our economic system not like criminal reckless endangerment or involuntary manslaughter? Why can’t we incarcerate individuals for taking on risks that are so excessive that they can bring down our whole economic system–and, worse, where taking on these risks would just have happened to make these individuals rich if they had worked? There are gray lines–what exactly is reckless and what is not? But this is also the case for non-financial reckless endangerment. The penalties could be proportional to the damages involved. Small bank, a misdemeanor. Large bank, a felony.

Won’t it be too expensive to prosecute? Only if we do not legislate corporate failure as prima-facie evidence of excessive risk-taking. (Again, the crime is not failing; it is allowing excessive risk.) Won’t it induce some managers to try to cover up until the situation ends up even worse, instead of fessing up earlier? Yes, but this is the case for any sanction.

Won’t it hurt the industry? Won’t it discourage attracting “the best” to Wall Street? Won’t it cost us in less financial innovation? Won’t some executives not wander off to other countries? Yes. Some smart people will leave the largest banks and funds, not willing to take the risks. But it’s not as if these smart people will sit around unemployed. There are plenty of other great ways to deploy their brains. They could work for smaller, less systematically important hedge funds and/or more heavily equity-financed funds. Heck, what if engineers started preferring engineering firms again instead of Wall Street?

But I doubt too many individuals will be leave. The rewards will still be very rich, even with five times the equity cushion that firms have today. Conservative, diversified, less-levered, smart lending and investing practices can carry very little risk. With more public disclosure, banks could become more cognizant of systemic risk. Today, much risk in the financial system is not incurred in the process of extending loans to individuals and non-financial corporations, it is incurred by financial firms betting against one another, and often with huge leverage extended to one another. Of course, it is true that we may lose some liquidity in some lending markets, but this is a cost of better systemic soundness. We can’t demand that banks make conservative loans and then lament that they don’t make more loans. (This applies especially but not only to the public’s and politicians’ attitudes about Fannie and Freddie.)

But, most importantly, worrying about too few smart people in large firms on Wall Street taking too few risks is like worrying about overshooting watering the Sahara desert because it could become a swamp. Yes, in principle, it could happen, but we are so far from an optimal balance – and will likely still be even after criminal penalties–that it’s not an important worry.

We need to find a balance that works for our economy. Right now, we err badly on the side of allowing almost unlimited risk-taking. We need to err on the side of reducing the banking risk incentives too much. Financial services is not where our economy needs the most innovation.

Of course, I have no illusions. Trusting government to do anything right is dangerous. And even if our public servants were all well-intended today, Wall Street will throw so much money at politicians, regulators, lobbyists, and lawyers, that it is extremely unlikely that criminal sanction legislation will ever pass. However, it is a tossup whether we are better off pursuing a tiny probability of passing effective regulation or a modest probability of passing ineffective regulation. Unfortunately, the stakes are high, and we are caught between a rock and a hard place.

Let me close with my opinion of Dodd-Frank and Obama. I congratulate them on their intent. They actually managed to bring financial reform back from the dead, after Wall Street had almost managed to slow the reform process down to a full stop. (Michele Bachmann (R-MN) has already proposed a full repeal of the “job-killing Dodd-Frank financial regulatory bill…” Even the fairly meager Dodd-Frank reform may not last.) Yet, I lament the presence of the actual law. Even though the world is better with Dodd-Frank than without (and especially if I am wrong about my prediction that its specific provisions will be toothless), the real harmful aspect of Dodd-Frank is (a) that it has preempted better legislation to deal with the underlying desire for risk-taking, and (b) that the public now mistakenly believes that the economic system is safer than it was. It is not.