Moral Hazard and Corporate Governance

I usually stick with the Economics side of my degree instead of the Finance when I blog because macroeconomics is highly linked to politics and policy.  Today, I’m going to switch over to the one field specialty I took in graduate school that’s not considered economics.  (My economics fields are monetary and international.)  My finance field is corporate finance.  The two theories I spend time researching  in the corporate area are two that are frequently at the middle of financial crisis.

Moral Hazard is a  problem in situations where there are multiple parties, differing levels of information about the situation, and differing levels of exposure to the risk inherent in the situation.   Evaluating how folks operate in different risky situations with varying amounts of information  using mathematical models is basically a big old exercise in calculus that I’m not going to do here.  The theory is a useful one that explains,as an example, why you drive faster if you’ve got a seatbelt on and are insured.  Basically, between seatbelts and insurance, you don’t feel as ‘at risk’ so you behave in a riskier way.

Corporate Governance Laws and Executive Compensation packages are designed to overcome the moral hazard implicit in one of the most basic moral hazard models.  It’s called the  principal-agent problem.  Basically this theory shows the problems that can occur when the owner(s) of a firm (the principal) hire managers (the agent) to run the firm.   The owners (like common stock shareholders) don’t have the same level of information about firm performance that the executives do.  They have to rely on the executives for information.  Also, the owners can loose lots of money if the executives make bad decisions and slack off and don’t work as hard as they should.  In this model, the principals have to find a contract that will force the agents to act in their interests.  They must force them to work hard and return the maximum wealth to the shareholders.  That’s what corporate governance laws and executive compensation packages are designed to do: align the interests of the executives and the shareholders.  If designed properly, they should eliminate the moral hazard problem.  Corporate Governance creates a more transparent environment where the executives can’t hide information.  Property designed executive compensation packages reward the executives for doing their best by shareholders.

So, what we have here right now has been a huge failure to communicate and perform on the part of the Agents and a lot of rage on the part of the principals and taxpayers that are now being asked to come to their rescue.  There’s a lot of outrage now about bankers’  bonuses.  Bonus packages are supposed to align the the interests of the shareholders and the executives.  So what’s the deal here?  Is it time to storm the castle ?  Will all our politicians (including the president) get more votes bashing bankers and continue this as the only response to this huge problem?  I mean, really, what could be more meaningful than a bunch of rich senators on a panel complaining about the way rich bankers got rich?

Many of these huge bonuses are contractual at this point and must be honored as such. However, contracts generally expires.  Then what?  What’s at the root of the problems and better yet, what can we do to prevent the problem from reoccurring?

One of them major problems has to do with how bonuses are set.  In the case of banks, many executive bonus pools are paid as a percentage of revenue and not profit.  This means that as long as they can churn up revenues and not worry about the losses and costs that push those revenues to negative profits, they still get paid.   Other things will go away because of the situation. One thing that bubbles do is inflate everything so just as banks paid too much for office space or branches, they paid too much for bankers also.  This particular part of the problem goes away with the bubble.   Some of the issues that could take care of this is to pay them over longer periods.  Additionally, bonuses in the form of shares are used to make management think more long term.  Bonuses can also contain claw back provisions where the  excessive risk-taking in the short-run can be punished with taking the bonuses back if the risks turn costly.  Shares can easily been taken back.  Cash bonuses are not as easy to recall.

The basic thing that needs to be looked at, still, remains firmly in the corporate governance area.  The boards and oversight agents actually cheered on the excessive risk-taking and poor underwriting practices during the housing crisis.  Risk managers, boards of directors, and regulators saw absolutely no problem in the behavior of management practically up to the moment the entire financial system came crashing down.  Again, the only term I can continue to use is oversight malpractice.  I apply this to Board of Directors, the Fed, the SEC, and the congressional committees responsible for the banking and financial system.  The UK has initiated a review of bank governance because they realize it is at the heart of the problem.  I’m still waiting on some response from our government.

The February 14th, 2009 edition of The Economist characterizes the Obama rescue plan as a ‘huge wasted opportunity in the economic crisis.”   The entire investment community has thumbed their noses also.  The equity markets are close to a five year low.  This is a vote of  no-confidence.

Alas, that opportunity was squandered. Mr Obama ceded control of the stimulus to the fractious congressional Democrats, allowing a plan that should have had broad support from both parties to become a divisive partisan battle. More serious still was Mr Geithner’s financial-rescue blueprint which, though touted as a bold departure from the incrementalism and uncertainty that had plagued the Bush administration’s Wall Street fixes, in fact looked depressingly like his predecessors’ efforts: timid, incomplete and short on detail. Despite talk of trillion-dollar sums, stockmarkets tumbled. Far from boosting confidence, Mr Obama seems at sea.

They characterize the entire plan as hopelessly inadequate and vague.  I wish I could see something that would change the assessment of the situation but I do not.

That makes the inadequacy of the financial rescue all the more regrettable. Fiscal stimulus, indispensable as it is, cannot create a lasting economic recovery in a country with a broken financial system. The lesson of big banking busts, such as Japan’s in the 1990s, is that debt-laden balance-sheets must be restructured and troubled banks fixed before real recoveries can take off. History also suggests that countries which address their banking crises quickly and creatively (as Sweden did in the early 1990s) do better than those that dither. This is expensive and painful, but cautious, penny-pinching governments end up paying more than those that tread boldly.

By any recent historical standards America’s banking bust is big (see article). The scale of troubled loans and the estimates of likely losses—which are now routinely put at over $2 trillion—suggest many of the country’s biggest banks may be insolvent. Their balance-sheets are clogged by hundreds of billions of dollars of “toxic” assets—the illiquid, complex and hard-to-price detritus of the mortgage bust, as well as growing numbers of non-housing loans that are souring thanks to the failing economy. Worse, banks’ balance-sheets are only one component of the credit bust. Most of the tightness of credit is owing to the collapse of “securitisation”, the packaging and selling of bundles of debts from credit cards to mortgages.

Perhaps what we are seeing now is an even bigger more expensive take on the Principal-Agent problem.  When we elect a president or senator or representative, we expect them to have their interests aligned with ours.  Yet, it appears that no matter what the party affiliation, we wind up with elected officials that represent the people that funded their campaigns not the people that voted for them.

Today, there is supposed to be the announcement of a plan to help out borrowers.  Some time soon, we’ll get another plan to hopefully put in reforms that will rebuild our broken financial system.  If the last 4 weeks are any indicator of what’s to come,  I’m thinking this will be a long precipitous drop to a bottom we’ve not even glimpsed or estimated yet.  At some point, some body needs to get it right.  Isn’t that what we elected a new regime to do?   Can I just suggest we stop the nationwide tour and work on the plan?  Speech giving is not a strategy.  Hope is not a plan.  Solutions do not come from teleprompters.

One Comment on “Moral Hazard and Corporate Governance”

  1. ea says:

    “Solutions do not come from teleprompters.”

    Wow, that would be a great sign to hold up at an Obama press conference or public appearance. I’ll give you a nickel if you do it.