Getting Incentives Right

Let our journalists help you make sense of the noise: Subscribe to the Mother Jones Daily newsletter and get a recap of news that matters.

Martin Wolf has a bit of an odd column today.  His basic point is that financial bubbles are generally caused by too much borrowed money:

At the heart of the financial industry are highly leveraged businesses….In a highly leveraged limited liability business, shareholders will rationally take excessive risks, since they enjoy all the upside but their downside is capped: they cannot lose more than their equity stake, however much the bank loses. In contemporary banks, leverage of 30 to one is normal. Higher leverage is not rare.

….A solution seems evident: let creditors lose. Rational creditors would then charge a premium for lending to higher-risk operations, leading to lower levels of leverage. One objection is that creditors may be ill-informed about the risks being run by banks they are lending to. But there is a more forceful objection: many creditors are protected by insurance backed by governments. Such insurance is motivated by the importance of financial institutions as sources of credit, on the asset side, and suppliers of money, on the liability side. As a result, creditors have little interest in the quality of a bank’s assets or in its strategy. They appear to have lent to a bank. In reality, they have lent to the state.

So far, so good. Even rational managers and shareholders have a big incentive to take outsize advantage of cheap money if it produces many years of great returns and only occasional big losses.  Ditto for lenders — especially if, in the case of catastrophe, they can expect to be protected by central bank guarantees of various sorts.  But then the column ends with this:

The unpleasant truth is that, today, the incentive to behave in this risky way is, if anything, even bigger than it was before the crisis. [Yikes! –ed.]

Regulatory reform cannot end with incentives. But it has to start from incentives. A business that is too big to fail cannot be run in the interests of shareholders, since it is no longer part of the market. Either it must be possible to close it down or it has to be run in a different way. It is as simple — and brutal — as that.

Wolf’s focus on abuse of leverage is right on target, as is his observation that regulation by itself isn’t enough to stop it.  Regulators will inevitably become captured, banks will figure out ways to get around them, and politicians will do nothing to stop it since that would run the risk of hurting the economy with an election coming up.  (And there’s always an election coming up.)

So what’s the answer?  The academic paper that inspired the column suggests that reforming executive compensation in the financial sector is part of the answer, but Wolf himself doesn’t really follow that up.  So we’re not left with much.  Saying that big banks “cannot be run in the interests of shareholders” is a provocative statement, but following that up by suggesting only that they need to be “run in a different way” isn’t a very provocative response.  Perhaps this column was a season finale cliffhanger and we have to wait until next week for the mind blowing conclusion?

THE TRUTH IS...

what drives Mother Jones' team of 50-plus journalists. The truth is powerful, as evidenced by how hard those with something to hide, or profit to gain, seek to discredit it. The truth, stated boldly and reported meticulously, is what draws so many readers to Mother Jones.

And the truth is, going into the final 4 days of the year we still needed to raise $TK to hit our $350,000 goal and start 2021 on track. It's nerve-wracking, wondering if the big spike we normally see at the end of December is going to be another thing that doesn't go as planned in 2020, or worse, if, now that Donald Trump is set to leave the White House (for longer than a taxpayer-funded golf trip to a property he owns), folks might be pulling back from fighting for the truth and a democracy and think the hard work is done.

It's not, and if you can right now, please consider a year-end donation to support our team's fearless nonprofit journalism so we can close that big fundraising gap and finish the year strong, ready for all that's ahead in 2021. Whether you can give $5 or $500, it all matters in keeping us charging hard, and we'd be grateful.

payment methods

THE TRUTH IS...

what drives Mother Jones' team of 50-plus journalists. The truth is powerful, as evidenced by how hard those with something to hide, or profit to gain, seek to discredit it. The truth, stated boldly and reported meticulously, is what draws so many readers to Mother Jones.

And the truth is, going into the final 4 days of the year we still needed to raise $TK to hit our $350,000 goal and start 2021 on track. It's nerve-wracking, wondering if the big spike we normally see at the end of December is going to be another thing that doesn't go as planned in 2020, or worse, if, now that Donald Trump is set to leave the White House (for longer than a taxpayer-funded golf trip to a property he owns), folks might be pulling back from fighting for the truth and a democracy and think the hard work is done.

It's not, and if you can right now, please consider a year-end donation to support our team's fearless nonprofit journalism so we can close that big fundraising gap and finish the year strong, ready for all that's ahead in 2021. Whether you can give $5 or $500, it all matters in keeping us charging hard, and we'd be grateful.

payment methods

We Recommend

Latest

Sign up for our free newsletter

Subscribe to the Mother Jones Daily to have our top stories delivered directly to your inbox.

Get our award-winning magazine

Save big on a full year of investigations, ideas, and insights.

Subscribe

Support our journalism

Help Mother Jones' reporters dig deep with a tax-deductible donation.

Donate