What is clear is that this crisis reveals deep flaws in the financial system. In light of the millions of Americans out of work and the costly bailouts, many understandably believe one of these flaws to be bankers without principles who took excessive risks and endangered the economy. Reforms proposed by the Obama administration reflect this perspective. These proposals include a new consumer finance protection administration, attempts to link pay to longer-term stock performance and capital regulation to limit access to extreme leverage.
Some version of these proposals will likely be implemented, but its ability to prevent another crisis is far from clear. First, many of the subprime loans that are thought to be predatory and would presumably be forbidden by the new consumer finance administration actually gave many families free housing for some time. Second, these free homes ultimately came at the expense of sophisticated bankers (at least those who were not bailed out) who owned lots of shares of their company’s stock. And third, there have already been several attempts at improved capital regulation, known as the Basel Agreements.
A less talked-about but potentially deeper flaw is: Where were the principals — the shareholders and boards of directors of these firms who should have watched the risks that their bankers took? After all, the shares of banks are mostly held by sophisticated institutional investors and not individual shareholders. One hears of few institutional investors who are objecting to the anticipated bonuses to be paid this year. Presumably, this is because they want finance firms to take such risks. The rewards from risky investments when taxpayers subsidize losses are apparently too great. Such distorted incentives lead banks to take on investment strategies that are on average profitable but blow up with a small probability.
From this perspective, proposals to better safeguard and buffer the system from such risk-taking are vital. One sensible approach is to push the hard-to-price exotic instruments behind the financial crisis, which are now traded over-the-counter, onto exchanges where they can be priced and the risks properly reflected on the balance sheets of firms. Another approach deserving of attention, and more on point than those currently being pushed by the White House, is to allow regulators to break up firms deemed too big to fail. Some argue that we need big banks to compete in the global market place, while others worry about the practicality of such a move. There are few good theories, however, or evidence for economies of scale in the finance industry more broadly and in risk-taking in particular. And this country has a history with breaking up big firms (including Standard Oil and AT&T) when they were perceived to pose a danger to the economy, and nothing disastrous happened afterward. The fate of these proposals, which are making their way through Congress, is uncertain at this point.
What is clear is that this crisis reveals just how important the finance sector is to the economy. Beyond the need for a healthy system to sustain economic activity, the banking industry had been one of the most innovative and vibrant in the world and was an important source of high wage jobs. It has attracted a disproportionate amount of talented young people over the past generation, but this crisis has left many of them literally without principals and in search of new ones. Cast in this light, it is natural that the government wants to protect banking. This intervention has returned some part of the industry to profitability and stabilized its jobs outlook.
But chances are that this job recovery will continue to be weak, because financial firms face uncertainty not only about the stability of markets but also about the prospect of reforms. Looking out further, firms in a subsidized banking industry will to attempt to merge to become even more too big to fail. This could lead to greater crises in the future. More importantly, these mega-firms could limit the growth of new and more innovative companies, stifling job creation in this sector.
What is clear is that we need wise financial reforms quickly.
Harrison Hong is the John Scully ’66 Professor of Economics and Finance. He can be reached at hhong@princeton.edu.
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