Fault Lines: How Hidden Fractures Still Threaten the World Economy (30 page)

Matters grow worse if, because of the extent of risk taking, everyone anticipates that when the risk actually materializes, the government or the Federal Reserve will be drawn in to support the markets underlying the tail risk, or the institutions taking it on. In that case, those taking on the tail risk will find it worthwhile even if it is common knowledge that they are doing so, because the government backstop will make it profitable. Few financial institutions will want to be left out of the orgy of risk taking. So what starts off as an attempt to take on hidden risk and fool the market will, if enough firms get in on the act and induce an anticipation of government intervention, become an overt and profitable play that is rewarded by the market.

If tail risk is knowingly taken, or knowingly encouraged by securities markets, the way to deal with it is to alter incentives throughout the corporate hierarchy, the financial firm’s liability structure, and its regulatory structure. One seemingly obvious way to reduce the perverse incentive to take tail risk before risk taking becomes systemic is to do away with all pay tied to performance: to pay bankers like bureaucrats. Of course, firms can offer other rewards for performance, such as status and promotions, that are harder to eliminate. And even if it were possible to prevent evasion of the rules, there would be another obvious downside; bankers would have no incentive to work hard or take calculated risks. In today’s competitive, fast-moving economy, bureaucratic bankers would not be an improvement over the status quo. What we need from bankers is competent risk management, not complete risk avoidance. So we have to find ways to reduce the incentive to take tail risk even while rewarding bankers for performance so that they continue to offer innovative products that meet customer needs and lend to the risky but potentially very successful start-up.

This means that wherever possible, the risk taker should suffer targeted penalties if the risk materializes, so that society does not feel the need to absolve them because the innocent, the connected, or the politically vocal will suffer alongside. Of course, extremely high penalties will deter even ordinary risk taking, so the penalties will have to be appropriately calibrated. It may also well be that no one, including markets, can anticipate some risks. To deal with such possibilities, it is necessary to build some private-sector buffers to absorb shocks, as well as make the system resilient to them. I will now be more specific.

The most obvious form of tail risk taking is conducted by individual traders or company units, as was the case at AIG’s Financial Products Division, whose staff benefited from the extraordinary profits and associated huge bonuses on the way up and were retained with high bonuses to clear up the mess they created on the way down. One way to make units internalize small-probability tail risks that senior management or risk managers may not see or understand is to hold a significant part of a unit’s bonuses in any year in escrow, subject to clawbacks based on the unit’s performance in subsequent years—a suggestion I made before banker bonuses became a political football.
⁶
Simply put, if a trader makes a hefty bonus this year, only a fraction should be paid out to her this year, with the remaining amount held back by the bank to be paid out over time on condition that her positions do not lose all the money earned this year in subsequent years. This will give the trader a longer horizon, creating some uncertainty about whether any tail risk she takes could actually hit before her bonus is paid, thus giving her greater incentive to avoid it.

Of course, such a compensation structure will be effective only if a trader knowingly takes tail risks, not if she is unintentionally guided into taking them. Crude limits on the positions individual traders or units are allowed to take, and mandatory diversification requirements, may also be necessary, not so much to prevent tail risk taking but to minimize the loss if it does occur.

The proposals above to manage tail risks presume that top management wants to curb such risk taking. I have discussed a number of reasons why CEOs might not want to do so, such as their desire to match the profits shown by other risk-taking managements and their insouciance about the downside because they believe that the government will intervene. Some old-time bankers reminisce fondly about the time when investment banks were partnerships, and partners had their entire wealth at stake. Given the size of banks today and their international sprawl, it would be difficult to convert them back into closely held partnerships in which mutual monitoring by partners inhibits excessive risk taking. And forcing banks to shrink might not make them safer. We have also seen that simply giving management an equity stake may not be enough—they realize enormous gains if the risk taking pays off but have limited liability if it does not.

Instead it may be useful to consider ways to place some of the burden of risk on top management, without necessarily having entire classes of claims being subject to that risk. For instance, the Squam Lake Working Group (a nonpartisan group convened by Professor Ken French of Dartmouth College after the recent crisis to propose reforms) has suggested not only holding back some portion of top management bonuses and reducing them if there are future losses—much like the clawbacks I discussed earlier—but also writing these “holdbacks” down if the firm has to be bailed out in any way. Thus the holdbacks would serve as junior equity and give strong incentives to management to take precautions to avoid a bailout.

The financial firm’s board is meant to be another check on mismanagement. But even when tail risk taking is not in the shareholders’ interests, the bank’s board of directors may not be an effective source of deterrence. Board members are generally poorly informed when they are truly independent, and excessively cozy with management when they are not. Lehman’s board, for instance, consisted of very respectable independent directors. But at the time it filed for bankruptcy in 2008, of the ten-member board, nine were retired, with four over the age of 75.
⁷
One was a theater producer, another a former Navy admiral. Only two had direct experience in the financial services industry. Although advanced age is no disqualification, it typically suggests some remove from the cut-and-thrust of modern finance. Such a board, whose risk committee met only twice a year, had only limited ability to monitor Lehman’s risk taking.

Boards can be strengthened by requiring more financial services expertise of directors, as well as by drawing them from outside Wall Street. Furthermore, a board can obtain better information if the risk managers in the firm are required to report directly to it on a regular basis. The board’s risk committee should also have regular meetings to discuss firmwide risk with unit heads across the firm, without top management present, so that they have a sense of what is going on from those who are closest to the action. Of course, if competent boards are propelled by the same risk-taking incentives as top management, we will have to look elsewhere for ways to discipline risk taking.

Could bank supervisors play a role in monitoring risk taking by top management, as a second line of defense beyond the board, so to speak? Some commentators, including, famously, Alan Greenspan, were skeptical that supervisors would be able to do so. Supervisors are typically less well paid than private-sector executives, though they have more job security. Except for those really motivated by public service, supervisors tend to be either less talented or extremely risk averse, neither of which is a particularly helpful attribute in modulating private sector risk taking. Nevertheless, supervisors have two strengths that can make them useful checks on private risk taking. First, they have different incentives: they focus more on the small-probability risks of disaster than does the private sector. Second, they can demand data from firms across the industry and obtain a very good picture of where risk concentrations are building up. Because the tail risks that matter most are those that the whole system is exposed to, well-informed supervisors can monitor aggregate financial-sector exposures and warn firms that are taking too much risk to cease and desist.
⁸
The key is to be neither so intrusive that supervisors constantly substitute their judgment for that of the private sector nor to be so laissez-faire that they ignore systemic risk buildup.

For such a system to work, we need better information. Currently, far too few financial institutions know on a daily basis what their risk exposures are: what might happen if interest rates move up by 25 basis points, if Italian government bonds are downgraded, or if a bank in Ohio is seized by regulators. As a consequence, the regulators and supervisors do not know, either. That AIG was in deep trouble seemed to be news to the regulators who were attempting to deal with Lehman’s impending failure—in part because AIG had found itself a weak regulator by buying a small savings and loan and ensuring its banking activities were regulated by the Office of Thrift Supervision.
⁹
In this day and age, for a regulator to be uninformed is unconscionable. Much of the process of acquiring and analyzing information can be automated. Regulators can require that this information be shared with them on a continuous basis, offering standard procedures and models with which to calculate the exposures. Standardization would be especially useful in the case of illiquid securities, assets, or positions, for which each institution currently calculates values and exposures in its own way, so that their reports are not comparable.

Of course, supervisors rarely find the right balance between intrusion and laissez-faire, and political pressures tend to make them excessively lax in booms and conservative in downturns, just the opposite of what their behavior ought to be. If the gathered information were made public, however, it could offer a measure of public oversight over supervision. For instance, once the information about aggregate exposures and individual financial-firm exposures was put together, much of it could be shared with the markets, after some delay, in a way that could be easily digested. Supervisors would be forced to explain their actions (or inaction) if exposures were seen to be excessive.

Regulatory authorities are often unwilling to reveal too much detail about exposures for fear that this may trigger the very panic they seek to avoid. Clearly, the wrong time to start revealing exposures is when the public is anxious about bank health. The right moment to start is in normal times, when no one is likely to panic. After that, if data on exposures are made public on a regular basis, the public can exert steady and healthy pressure on the financial firms.

Public exposure can reduce tail risk taking in its early stages, for tail risk is of significant value to management at that stage only if the public is unaware of the extent of the company’s exposure to risk. Bond holders will typically not be happy to learn that the hundreds of millions in dollars of profits made in the past quarter came from taking on trillions of dollars’ worth of exposure to particular rare events.

Public exposure can work by making the financial claimants on a financial firm check excess risk taking. Of course, equity holders, who get much of the benefit, may actually favor tail risk taking if the financial firm’s equity cushion is thin relative to the size of the firm: they have little to lose. So a larger capital cushion is necessary to deter risk taking. Below, I suggest ways that such capital can be raised. Also, as I argue above, many debt holders—not just insured depositors but even holders of long-term unsecured debt—thought they would be bailed out by the government, so the interest rate they demanded did not adjust upward as the financial firm took more risk. But debt holders could be an effective constraint on risky behavior if they bore the downside risk, for their future anticipated losses would be reflected in the higher interest rate they demanded from the financial firm. If interest rates move up substantially on a large portion of the financial firm’s debt when it takes more risk, thereby reducing profits, both management and the board may be deterred from risky behavior. At the very least, such an increase in rates paid will be a strong signal to the public and to regulators that the financial firm is taking substantially more risk. Therefore, regulatory reform should focus on ensuring that an important segment of a financial firm’s debt holders know they should expect painful losses if the financial firm takes too much risk.

But neither equity holders nor debt holders will worry much once risk taking becomes so systemic that the market comes to rely on government intervention to prop up markets when the risk hits. In that situation, management and stockholders or bondholders unite to see risk taking as a value-maximizing activity. And if the firm is deemed too systemically important to be allowed by the authorities to fail, the financial firm’s investors are unlikely to ever bear the full cost of big losses. This is a situation tailor-made for encouraging tail risk taking, because the firm makes a lot of profits in good times—everyone purchases tail risk insurance from firms like AIG that will be propped up by the government—and AIG runs to the government for a bailout if the costly tail risk ever hits. Let us take these situations in turn.

With the government so heavily involved in mortgage lending, both directly through the FHA and Ginnie Mae and indirectly through Fannie Mae and Freddie Mac, there was little chance that the market for housing finance, especially subprime housing finance, would be left unsupported even if a big shock hit. Similarly, the Fed and Treasury have supported virtually all the big banks that chose to take liquidity risk.

Clearly, the way to reduce tail risk taking under these circumstances is to back off from government intervention, to the extent possible. There is no inherent reason why the government should have such a large presence in the market for housing finance, other than the fact that the middle class has grown used to implicit housing subsidies. Government conservatorship of Fannie and Freddie gives it an opportunity to create true private-sector housing finance by breaking up these monoliths and creating a handful of private entities, none of which have an implicit government guarantee. At the same time, both the FHA and Ginnie Mae should be shrunk steadily. Although some think the fickleness of the private sector—as evidenced by the current drying up of private subprime housing finance—is a reason for the government to maintain its presence, it is the unsustainable levels to which house prices have been pushed, in part because of that very government presence, that has caused private finance to dry up.