Roubini: Gordon Gekko Reborn

This post talked about the negative consequences of the erosion of societal norms that regulate market behavior in the health care industry when significant market failures are present, but health care isn't the only place where norms are eroding or absent altogether. Nouriel Roubini says we should give up on the idea that teaching morality and values in business school will regulate behavior appropriately, it's never worked and it won't work now. The only choice is a strong government hand:

Gordon Gekko Reborn, by Nouriel Roubini, Commentary, Project Syndicate: In the 1987 film Wall Street, the character Gordon Gekko famously declared, “Greed is good.” ... 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. ...

[A]ny reform of regulation and supervision will fail to control bubbles and excesses unless several ... fundamental aspects of the financial system are changed.

First, compensation schemes must be radically altered through regulation... 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. ... 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. ... At the same time, there is a double agency problem, as ... 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. ... 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.

No matter what we do, we will never be able to guarantee that we will never have another crisis. Regulatory and institutional reform can make a crisis less likely, but it's almost a certainty that someday, tomorrow or decades from now, another crisis will occur. For that reason, we need to institute reforms that insulate the broader economy from collapse of the financial sector. I would have added strict limits on leverage to the list as a means of limiting the damage when the next meltdown does occur.