Saturday, January 31, 2009

Bad banking drives out good

I heard this quote from the CEO of Standard Chartered Bank on Radio 4's Today programme this morning, and it summarises the problem very well. (Its also a reference to Gresham's Law.)

Its become a commonplace to simply blame the credit crunch on "stupid, greedy bankers". The trouble is, suppose you were a smart, frugal banker five years ago. Your exceptional brains let you see that subprime self-certified mortgages were a bad idea, and therefore anything built on them was clearly going to collapse. Therefore you weren't going to invest in that part of the market.

The trouble is, you would have had years of below-average results. Your clients and employers would be looking at your competitors and pointing out how bad your results were. Even if your clients were prepared to listen to your explanations, many are under a legal obligation to maximise their investment returns, and their customers will be less sophisticated and correspondingly less willing to listen to complicated explanations about why their pension is so much less than their neighbours.

So you get removed from your job, and someone else is put in who is willing to do what it takes to deliver market returns.

Looked at from an abstract point of view the game resembles a "Tragedy of the Commons". A banker who gets good returns while taking hidden risks is like the commoner who puts an extra cow on the common pasture. He gets richer while all his neigbours get a little poorer. So everyone else is forced to do likewise, even though everyone can see that collectively this is going to lead to ruin. And so the game goes.

The traditional solutions to the Tragedy of the Commons are:

  1. Property rights. Divide up the commons into individual plots and allocate them to the commoners. Failing that, give each commoner a tradeable right to put exactly one cow on the commons.
  2. Regulation. Make a law that each person can only put one cow on the commons.
The question is, how to apply this to the finance industry. In this case cows are equivalent to risk. Banks have had "risk management" departments for years, but risk turns out to be very difficult to measure. Its as if our commoners have invisible cows: verifying the numbers is impossible, although I've previously posted a suggestion for making the cows more visible.

So without this, what can we do to prevent the next big bust? It doesn't look like there is anything. As memories of this bust fade and the people who experienced it retire, a new generation of bankers will come along with a new ingenious method for hiding risk, and once again bad banking will drive out the good until the whole thing collapses once more.


Jordan Henderson said...

Another way bad banking is driving out good is that the bad banks are beneficiaries of TARP money and may have used that money, in some cases, to buy other banks that perhaps are better capitalized and did not get TARP money.

I understand there's some concern about PNCs purchase of NCC, for example.

Anonymous said...

Tight regulation kept our banking system safe for seventy years. When the senate banking committee removed those regulations in the late 90s it the system collaped in ten years. Its not difficult to connect the dots.

Paul Johnson said...

Tight regulation:

Trouble is, regulation isn't independent of the market it governs. The theory is that the regulators set the rules and the industry deals with it. But in practice the industry has a lot of say in what the rules are. The phenomenon is known as "regulatory capture".