Washington Post Crashed-and-Burned-and-Smoking Watch
links for 2009-10-24

Wisest Thing I Have Read This Month

I keep looking at this, and thinking I will come back to it when I have an even wiser comment to make about it. But I don't.

Economist Free Exchange:

A few comments about risk: FELIX SALMON quotes one of his commenters, who writes:

The person most willing to take on risk is the one unaware he is doing so. He charges no risk premium… The resulting market equilibrium is that the guy who is unaware of the risk ends up loaded with it. Then the music stops.

The Epicurean Dealmaker, as part of his epic blog series on compensation, says:

Notwithstanding what legions of indignant and self-righteous commentators contend, the incentive system currently in place operates exactly as most of them propose: a large portion of banker pay is deferred for years and is tightly tied to the overall health and success of the firm. Bankers are not incentivized to print huge risky trades and run away as soon as they collect their bonus at the end of the year. In fact, they are more closely tied to the long-term health of the firm and its stock price than any other stakeholder. They just can't do anything about it. Unfortunately for them and for us, such a system does not seem to have prevented anything.

And Kevin Drum adds:

The problem wasn't so much that bankers didn't care about long-term results as it was that they never realized they were taking on so much risk in the first place. They thought they had safely hedged it all away. Reining in compensation may still be a good idea, but it's just a backstop. The real fixes to the system are deeper and more fundamental.

I would say that whether the problem is that bankers can't recognise risk when they see it or recognise it but are incentivised by their pay structures to embrace it, a good policy response is to increase capital requirements.