Surveying the world’s financial chaos, my colleague Robert J. Samuelson declared last week that “capitalism’s most dangerous enemies are capitalists.” This is the truth, but not the whole truth: There are constructive capitalists as well as dangerous ones. If election-year pressure for a clampdown on Wall Street starts rising, it will be vital not to lump the whole financial world together. A policy response has to distinguish between stabilizing players and destabilizing ones.
Stabilizing financial institutions have sensible incentives. People get paid to earn profits and manage risk at the same time. Despite how they are vilified, the majority of hedge funds are in this category.
Destabilizing financial institutions have skewed incentives. People discount risk and pursue profit recklessly because of their reward structure. Despite their reputation as the grown-ups in the system, the big investment banks suffer particularly from this skewing of incentives.
Hedge funds are having a rough month right now, but they have generally weathered the market chaos with relatively few losses. A smart player named John Paulson personally earned at least $3 billion by betting that the subprime bubble would pop; he did the whole world a favor, since his trading prevented the bubble from inflating even more than it might have otherwise. Now that the bubble is history, other hedge funds are swooping in to recapitalize flailing corners of the market. A big fund called Citadel has propped up the online brokerage E-Trade.
Contrast that with the investment banks. Giant after lumbering giant has reported mega-losses on subprime mortgages or, in the case of Societe Generale last week, on an extraordinary failure to control a rogue trader. The share prices of Bear Stearns and Citigroup have fallen by half over the past year; Merrill Lynch is down 40 percent. Stress at the banks makes it harder for companies to borrow; the entire economy is saddled with a “credit crunch.” The nightmare that a wounded bank might actually go under terrifies regulators, which goes some way toward explaining last week’s panicky decision by the Fed to slash short-term interest rates.
Of course, the picture could change instantly. Maybe next week a giant hedge fund will blow up. Because funds often mimic each other’s trading strategies, reasonable people worry that a sudden tightening of credit will force them to dump near-identical positions; the pressure of simultaneous selling could cause hedge holdings to crash. For a few nervous days in August, this seemed to be happening, and there are rumors of fresh trouble now. But while the risk of “crowded” trades is genuine, hedge funds have managed it successfully, at least so far. The chief exceptions have been the hedge-fund subsidiaries of—you guessed it—those reckless investment banks.
Incentives explain this contrast between hedge funds and the banks. Hedge-fund managers typically have skin in the game. They invest a significant proportion of their own wealth alongside that of their clients, so if they buy a pile of toxic mortgage securities, they risk poisoning themselves. In contrast, bankers bet with their bank’s capital rather than their own. If the bet goes right, they get a huge bonus; if it misfires, that’s the shareholders’ problem. Naturally, this heads-I-win, tails-you-lose equation creates a lot of high-stakes coin-flipping. Rational bank employees take as much risk as they can.
It gets worse. Many investment strategies are fully expected to cost shareholders billions, yet they remain attractive to bankers. Suppose that a risky subprime mortgage bond pays out a juicy 20 percent per year but is projected to default after five years. This means that buying the bond will deliver a banker four years of spectacular bonuses before hammering the shareholder in year five. Of course, banks have risk-control departments, and reckless bankers can lose their jobs. But is it any wonder that, faced with these incentives, bankers loaded up on precisely those bonds?
The banks’ perverse incentives are the root cause of the past year’s turmoil. It is wrong to blame financial engineering: The slicing and dicing of mortgages is a good thing because it allows risk to be diversified. It is a digression to blame the credit-rating agencies that opined on the riskiness of financial instruments while being paid by their designers: The real question is why investors relied on the raters’ obviously conflicted advice. And it is fruitless to blame “leverage,” the vast borrowing that is layered into every crevice of the system. It is too easy to sidestep regulations designed to bring the amount of leverage down.
The right lesson from the turmoil is that banks must reward bankers who earn profits on a multi-year horizon. They must reform their incentives so that they become more like hedge funds. Politicians can call for this, and regulators can prod helpfully. But the banks’ big shareholders will have to drive the process. The rejuvenation of capitalism must come from the capitalists themselves.
This article appears in full on CFR.org by permission of its original publisher. It was originally available here.