Sunday, September 27, 2009

Banks don't work in free markets either: bank regulation and the role of government (Part 1)

In past posts here and here, I’ve argued that health insurance can’t function in a free market. Today I’m turning my attention to banks.

There’s talk resurfacing of bank executive pay restrictions, and unsurprisingly, the Wall Street Journal is of the view that executive pay had nothing to do with the banking crisis. The Journal piece is not without its merits, but it falls victim to basic conservative platitudes the crisis dismantled – the fetishizing of individualism and unquestioning belief that self-interested markets are always self-correcting.

The argument against regulating bank executive pay follows two main thrusts:

  1. Ignorance of risks led to the banking meltdown, not compensation. “Bank CEOs held about 10 times as much of their banks' stock as they were typically paid per year. Deliberately courting risk would have put their own fortunes at risk.” Lehman’s Richard Full, for example, reportedly lost $1 billion. In fact, banks whose executives owned more stock did worse than those with less stock. Since executives did worse when their incentives were ostensibly best-aligned with their banks’ long-term interests (stock price performance), compensation could not be the root cause of the problem.
  1. Regulations impede the ability of the market to reward good ideas and punish bad ones. Capitalism is inherently about giving a variety of ideas the chance to compete, so regulating pay prevents companies from experimenting with different methods of compensating their employees and rewarding those with the best ideas.

The first argument’s basic assumption is that owning a bank stock does, in fact, align executives’ incentives with the bank's long-term interests. There are a few reason that's wrong. First, when bank executives don’t have to hold onto their stocks over the long-term, they are able to cash in on short-term profits. Richard Fuld might have lost $1 billion when Lehman went bankrupt, but he had still cashed in on $350 million in the eight years before its collapse – a nice cushion from which to gamble on your company’s future.

Free marketers will, of course, argue as they always do that if you just left the market alone, it would work its magic and solve all these problems. If executive pay was really such a detriment to performance, smart investors would buy shares of the poorly performing firm, correct the incentive structure to improve management decision-making, and reap the profits. Therefore, compensation cannot have caused the crisis.

The problem is that “smart investors’” do not actually share the long-term interests of the company – nor can they in a free market. Rather, their incentive is to buy stock and flip it for a quick profit to reinvest in hotter opportunities.

Traditionally, capitalism meant direct investment in relatively durable and illiquid assets such as land and factories. An industrialist who invested millions of dollars in factories and equipment could not easily sell those assets, and therefore would take care to manage them well to increase their value over the long-term.

But as capital markets have grown more liquid, investors’ interests have become increasingly short-term. The rise of electronic exchanges has reduced transaction costs and made it cheaper to cash out of investments, while sophisticated statistical techniques have made it easier to find the highest-return short-term opportunities in which to reinvest the profits. It’s a “keeping up with the Joneses” mentality – the easier it is to buy and sell stocks, the less satisfied you are with your current investments’ returns, and the more you ask yourself, “could I be getting a better return elsewhere?” $1,000 invested in a company earning a respectable 8% a year is $1,000 that could be invested in a company earning 10%. That’s how hedge funds work – identify the hottest short-term gainers, then cash out and use the profits to buy next quarter’s short-term gainer.

The evidence bears this out. Since 1960, the average holding period of stocks has fallen from 100 months to just 9 months; in 2007, this was 5.8 months for Citigroup, and a remarkable 2.5 months for Lehman Brothers. In other words, while investors in 1960 gave management 8 years to produce acceptable returns, today’s CEO earns shareholders’ wrath after less than one.

In such an impatient environment, there’s enormous pressure on CEOs to manage the company to hit quarterly numbers, regardless of the company’s long-term best interest. Miss analysts’ earnings targets, and the stock price goes down. If shareholders’ demands for higher returns aren’t met, they can easily sell their stock in favor of a company whose CEO is willing to oblige their impatience, driving down the more prudent firm’s stock price – and with it, the CEO’s pay. If I’m a shareholder in a “plain vanilla” bank earning respectable returns, but see other banks generating huge profits on exotic financial products, I’m going to demand that the CEO get in on the bonanza no matter the risk – after all, I can cash out after 9 months.

Theoretically, a CEO should have the discipline to ignore short-term stock price dips in the expectation of a long-term rise – provided, of course, that the CEO can keep his job long enough to realize those returns. And that’s the other half of the problem – as shareholders have grown more demanding, they have shown increasing willingness to fire CEOs over shorter performance periods. According to consulting firm Booz Allen Hamilton, CEO turnover increased 59% from 1995-2006, with “performance-related turnover” jumping an astonishing 318%. The fact that banks do worse when their executives own more stock actually proves the crisis was tied to compensation: to maximize pay, executives felt they had to push the stock price up as high as it would go as quickly as possible before they might get fired or jump to another company.

And even if the CEO does keep his job, remember, it’s the shareholders who write top executives’ compensation packages. Since shareholders’ incentive is to maximize short-term returns, they will always construct compensation packages that encourage short-term behavior. Thus, except in the rare cases that a company is owned by buy-and-hold shareholders, a publicly-traded firm in the absence of government regulation can never have a compensation plan aligned with its long-term interests.

I’m not the first person to point out problems in shareholder capitalism. After all, it was John Maynard Keynes who remarked, “It is generally agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of Stock Exchanges.”

What I think it is important to realize is that the current proposed pay reforms don’t go far enough, because just targeting bankers doesn’t change the fundamental incentive structure underlying how decisions at companies get made. The problem isn’t the bankers themselves – it’s with the people who choose the bankers and design their pay packages in the first place: the shareholders. The aim of regulation shouldn’t be to mandate how companies pay their employees, but rather to prevent company’s shareholders from cashing out too easily. I’d suggest a 70% capital gains tax on stocks held less than 3 months, 60% for stocks held less than 6 months, and 50% for stocks held less than a year. (Obviously not scientifically chosen numbers.)

Free market types would fire back that such taxes would hamper investment by making it more expensive. This is nonsense. Except during an initial or follow-on public offering, buying a stock is not investment – it’s speculation. Buying stock during an IPO gives the company capital with which it can buy equipment or finance other investment activity. By contrast, when I buy stock of a publicly-traded company, I’m buying it not from the firm, but from the previous owner of the stock – the company sees none of that money and does not benefit from my stock purchase. I’m only speculating that the price of stock will rise in the future. The vast majority of stock market transactions thus serve no social purpose.

Of course, if you go back to the beginning of the post, there were two arguments, and free marketers still have the second one left untouched – that is, the importance of allowing losing investments to fail. Some level of risk-taking is good for the economy, sometimes even big risks that are likely to fail but could produce breakthrough innovations. What if the government had told investors not to invest in risky ventures like the PC or the Internet? The best way to reduce bad risk-taking over the long-term is to allow investors to experiment and learn through failure; government regulation, on the other hand, will reduce appetite for good and bad risks alike.

It’s a formidable argument. Experimentation and failure is the lifeblood of the economy – and of society – so anything that risks stifling innovation should be looked on with extreme scrutiny.

The answer is coming in a subsequent post, so check back soon.

Related posts:

WSJ inadvertently supports case for health care reform: do you want to trust your health to profit and loss?

There's no money in selling insurance to sick people: more reasons free markets don't work in health care

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