In this Preface, we offer some analysis of the 2008-2009 financial crisis and its implications for financial industry reform and research. We primarily focus on issues relating to transparency and the measurement of risk and how these are affected by management incentives that are often misaligned with the incentives of those who are exposed in various ways to the risk being measured. In the aftermath of the crisis many have called for increased transparency; we suggest that while transparency is no doubt a desirable goal in many ways, enhancing it could prove to be quite difficult.
I found this particular paragraph of interest:
As established economics tells us, and as we are reminded almost daily by the financial media, incentives to take on risk are magnified in “heads I win and tails someone else loses” situations. In particular, implicit government insurance (e.g., too-big-to-fail insurance) potentially leads financial institutions to take on socially undesirable levels of risk, unless the government can somehow magically
and instantly adjust for the level of risk taken and perfectly price and charge upfront for the implicit insurance it provides. Financial liberalization permitted the financial sector to take on more leverage and more risk, and the incentives of managers and others all but guaranteed that would happen. There is certainly supporting anecdotal evidence of “risk-be-damned” behavior by large financial players prior to the crisis, e.g.: “[A former senior Lehman banker] recalls vividly the days in early 2007 at Lehman when his financial models began to throw up more warnings showing delinquencies and defaults, and he remembers colleagues on his desk raising questions about loan quality. But he said the firm’s ranking as
the top loan originator on Wall Street, not to mention the pressures put on the desk by Lehman’s growth-obsessed leadership, made it difficult for even the most senior executives to raise questions” (New York Times, September 13, 2008 p. 7).
Of course, different financial institutions have different cultures and compensation plans. All that economics can say is that implicit government insurance,
among other things, creates incentives that can lead to more-than-otherwise prudent risk-taking. Management hubris or over-confidence undoubtedly played a role — the bail-out insurance simply lowers the downside costs of that behavior. The stunning magnitude of the bail-outs that did occur make it plausible that they played a major role in prior decision-making: Alessandri and Haldane (2009)
calculate that “the scale of intervention to support the banks in the UK, US, and the euro-area during the current crisis…totals over $14 trillion or almost a quarter of global GDP. It dwarfs any previous state
support of the banking system” (p. 2).
After reading many of the recent accounts of the lead-up to the financial crisis, I do wonder exactly how much of the problem was with the models per se, and how much was organizational/institutional incentives to ignore unwelcome news brought to executives by the modelers.