Summary:
Chris Dillow argues that the traditional capitalist ownership structure is responsible for the credit crunch, not free markets as others have argued. Banks lost money on mortgage derivatives because of principal-agent failings, i.e. bosses (principals) don't know what the traders (agents) are doing. Traders have an incentive to take risk: life-changing bonus; gains exceeds benefits of prudence. Also, little pressure upon banks' executives to be prudent because when shareholding is dispersed, no individual shareholder has much incentive to rein in management. There has been more "bad" financial innovation that good ones. With good financial innovation it is very difficult for anyone to own its beneficial effects, it's a public good. Gains from “bad” financial innovation are more appropriable, hence we get more of it. Finally, banks' reluctance to lend to each other stems from the inability of management of such complex organisations to know everything. Banks should become more like venture capitalists, i.e. using an internal market, allocating capital to semi-independent divisions, which put in their own capital. (Published: 12/09/08)
Notes:
- Samuel Brittan and Anatole Kaletsky: credit crunch is undermining the case for free market capitalism
- but: crucial distinction between free markets and traditional capitalist ownership structures
- credit crunch does more to highlight the failing of the latter than of free markets
- Four reasons
- Banks lost money on mortgage derivatives because of principal-agent failings
- principals (banks’ bosses) didn’t understand what agents (traders) were doing,
- traders had incentives to take on excessive risk
- because the gains from doing so - a life-changing bonus - exceeded the benefits of prudence.
- Banks have been reluctant to lend to each other
- not so much because each bank fears its counterparty will not repay the money
- but: because they fear they’ll need the money themselves
- because banks just don’t know what sort of losses they are sitting on
- it’s impossible for managers of such complex organizations to know everything
- Banks are under-capitalized because chief executives have traditionally had incentives to maximize earnings by using leverage
- pressure upon them to be more prudent has been absent partly
- because when shareholding is dispersed, no individual shareholder has much incentive to rein in management
- [note: is shareholding too dispersed? 70% of all stock in America is now owned by financial institutions; as John Bogle said, in relation to Enron-type scandals, "the problem is that shareholders aren't owners anymore, they're agents of owners, and they do not actively engage in corporate governance, making sure that companies are managed for their shareholders etc.; instead they are more actively engaged in trading pieces of paper back and forth and they don't seem to care much about anything except whether the CEO meets the earnings expectations he's promised or doesn't; sometimes these expectations are met by fair means, but sometimes by foul ones" - like Dillow, Bogle also focuses on the ownership, but he blames it on the traditional owners capitalism having been replaced by managers capitalism]
- Good financial innovation has been lacking
- because it’s very difficult for anyone to own its beneficial effects;
- gains from “bad” financial innovation are more appropriable.
- so we get more of it
- e.g. overly complex mortgage derivatives
- solution
- not nationalization
- bad way of solving principal agent problems
- perhaps instead, banks should make more use of internal markets
- i.e. should become more like venture capitalists
- allocating capital to semi-independent divisions, which put in their own capital
- would restrain traders’ risk-taking
- as they can not so easily hide behind the fact that losses are spread over the whole firm
- would reduce the problem of asymmetric information between banks’ senior managers and trading desks
- as there’s a simpler test of how well the latter do: whether they can hand over enough hard cash to cover their required returns
