After the Storm
Gordon Gekko Reborn
Nouriel Roubini
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NEW YORK – In the 1987 film Wall Street, the character Gordon Gekko famously declared, “Greed is good.” His creed became the ethos of a decade of corporate and financial-sector excesses that ended in the late 1980’s collapse of the junk-bond market and the Savings & Loan crisis. Gekko himself was packed off to prison.
A generation later, the sequel to Wall Street – to be released next month – sees Gekko released from jail and returned to the financial world. His reappearance comes just as the credit bubble fueled by the sub-prime mortgage boom is about to burst, triggering the worst financial and economic crisis since the Great Depression.
The “Greed is good” mentality is a regular feature of financial crises. But were the traders and bankers of the sub-prime saga more greedy, arrogant, and immoral than the Gekkos of the 1980’s? Not really, because greed and amorality in financial markets have been common throughout the ages.
Teaching morality and values in business schools will not tame such behavior, but changing the incentives that reward short-term profits and lead bankers and traders to take excessive risks will. The bankers and traders of the latest crisis responded rationally to compensation and bonus schemes that allowed them to assume a lot of leverage and ensured large bonuses, but that were almost guaranteed to bankrupt a large number of financial institutions in the end.
To avoid such excesses, it is not enough to rely on better regulation and supervision, for three reasons:
· Smart and greedy bankers and traders will always find ways to circumvent new rules;
· CEOs and boards of directors of financial firms – let alone regulators and supervisors – cannot effectively monitor the risks and behaviors of thousands of separate profit and loss centers in a firm, as each trader and banker is a separate P&L with its own capital at risk;
· CEOs and boards are themselves subject to major conflicts of interest, because they don’t represent the true interest of their firms’ ultimate shareholders.
As a result, any reform of regulation and supervision will fail to control bubbles and excesses unless several other fundamental aspects of the financial system are changed.
First, compensation schemes must be radically altered through regulation, as banks will not do it themselves for fear of losing talented people to competitors. In particular, bonuses based on medium-term results of risky trades and investments must supplant bonuses based on short-term outcomes.
Second, repeal of the Glass-Steagall Act, which separated commercial and investment banking, was a mistake. The old model of private partnerships – in which partners had an incentive to monitor each other to avoid reckless investments – gave way to one of public companies aggressively competing with each other and with commercial banks to achieve ever-rising profitability, which was achievable only with reckless levels of leverage.
Similarly, the move from a lending model of “originate and hold” to one of “originate and distribute” based on securitization led to a massive transfer of risk. No player but the last in the securitization chain was exposed to the ultimate credit risk; the rest simply raked in high fees and commissions.
Third, financial markets and financial firms have become a nexus of conflicts of interest that must be unwound. These conflicts are inbuilt, because firms that engage in commercial banking, investment banking, proprietary trading, market making and dealing, insurance, asset management, private equity, hedge-fund activities, and other services are on every side of every deal (the recent case of Goldman Sachs was just the tip of the iceberg).
There are also massive agency problems in the financial system, because principals (such as shareholders) cannot properly monitor the actions of agents (CEOs, managers, traders, bankers) that pursue their own interest. Moreover, the problem is not just that long-term shareholders are shafted by greedy short-term agents; even the shareholders have agency problems. If financial institutions do not have enough capital, and shareholders don’t have enough of their own skin in the game, they will push CEOs and bankers to take on too much leverage and risks, because their own net worth is not at stake.
At the same time, there is a double agency problem, as the ultimate shareholders – individual shareholders – don’t directly control boards and CEOs. These shareholders are represented by institutional investors (pension funds, etc.) whose interests, agendas, and cozy relationships often align them more closely with firms’ CEOs and managers. Thus, repeated financial crises are also the result of a failed system of corporate governance.
Fourth, greed cannot be controlled by any appeal to morality and values. Greed has to be controlled by fear of loss, which derives from knowledge that the reckless institutions and agents will not be bailed out. The systematic bailouts of the latest crisis – however necessary to avoid a global meltdown – worsened this moral-hazard problem. Not only were “too big to fail” financial institutions bailed out, but the distortion has become worse as these institutions have become – via financial-sector consolidation – even bigger. If an institution is too big to fail, it is too big and should be broken up.
Unless we make these radical reforms, new Gordon Gekkos – and Charles Ponzis – will emerge. For each chastised and born-again Gekko – as the Gekko in the new Wall Street is – hundreds of meaner and greedier ones will be born.
Nouriel Roubini is Professor of Economics at the Stern School of Business, NYU, Chairman of Roubini Global Economics (www.roubini.com), and co-author of the book Crisis Economics. He has a cameo role in Oliver Stone’s new film Wall Street: Money Never Sleeps.
Copyright: Project Syndicate, 2010.
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gyif 07:24 17 Aug 10
What we know is that the TBTF banks are too intertwined with the government and Washington politicians, and wield too much power. While we cannot legislate greed, measures can be taken to correct if not compel corporations to comply via strict regulations. Laws that threaten loss of any and all financial remuneration and the notion that these laws will be carried out may possibly act as deterrents providing that our legal system is not gamed by CEO's of the banking industry. Seems that the current administration is attempting to correct some of the misdeeds committed by Wall Street however the pushback from every direction shows much stronger muscle, even though it is to the detrement of the rest of the country. Their greed and unconcern for humanity speak to the character of the players. Until and unless the administration finds a way to breakthrough this mindset, we will most likely see further erosion and disrepair of our overall state of affairs. What we need here is a comprehensive program to counteract further aggression on Wall Street.
damianoloan 04:32 18 Aug 10
I have a question relating to the 'too big to fail' phenomenon which I haven't seen answered thus far.
Given that growth has survived the crisis as the primary objective of business, despite the apparent consensus that there is a maximum desirable size for any particular company or group, with non-existence presumably forming the least desirable size, does this mean that we should now be able to calculate a formula for the optimum size of a company/group relevant to the wider economy?
evera 08:34 09 Sep 10
A fool and his money, are soon sepparated.
Solution is education, and having educated friends. Even with no financial education, with just stories of failure of the gullible.
Nico 12:52 14 Aug 10
What a fetishist disavoawl of reality. We know that regulations, breaking-up TBTF banks, etc., will all eventually come to naught, because we refuse to understand that we live in an economy and society characterized by institutionalized class power, i.e. hegemonic apparatuses and organic intellectuals. Unlike the Chinese - that thanks to a communist revolution, swept the parasitic order away - their government controls the levers of financial power able to create the demand mgmt of Keynes dreams; or FDR, who's own Bonapartist moment in the 1930s allowed him to imposed the sorts of laws that were needed to safeguard capitalism from its own immanent collapse. Problematically today Obama and the G20 gang are too intertwined with Wall St. - or its parasitic equivalents throughout the world - to do anything to prevent another collapse. The rot of liberal democracy is evident to everyone, rational policy making - the sin qua non of lib-dem - can no longer be said to exist - assuming it ever really did. Therefore, ironically, by saving the financial system and averting another Great Depression, we have actually strengthen the same forces that created the crisis in the first place and it will culminate into a greater crisis, who's consequences I cannot yet fathom.
We may not be able to exercise "greed" out a system premised on it, but shouldn't that indicate that the system is cannibalistic and inherently crisis-prone? Capitalism, in its idealist justifications, is a system that is premised on the betterment of all people's through growth; thus, the treatment of all humans as ends, not means; however, this crisis highlights how ridiculous, self-serving, and inherently contradictory such justifications are. Let the mad dance of disavowals continue, hasta el fin!
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