As an economist I have always believed that “Market Discipline” would provide the means of preventing excess risk and imprudent actions on the part of corporate executives. I believed that ENRON and World Com were aberrations. I did wonder, however, how these aberrations could occur.
The recent meltdown in the mortgage markets has convinced me that the excessive risk taking is not an aberration. Rather, it is built into the very fabric of the modern financial system. How this came about is very simple:
For “Market Discipline” to work the participants and decision makers in the system have to be subject to both the rewards and the potential losses from assuming high risk. When the decision makers are subject to the potential losses they tend to act in a prudent manner. The problem lies in the fact that the remuneration systems in place in today’s markets provide very high rewards to executives who engage in successful risk taking. On the other hand, if the risks are unsuccessful, there is no penalty to the decision makers. They may lose their jobs, but their separation packages have such high payouts that the losses are limited. Just look at the Fannie Mae and Freddie Mac CEO’s. The payouts are in excess of $10 million each. Bears Stearns had similar arrangements and I’m sure that Lehman executives will also come out well off. The biggest losers are the shareholders and the public. The people making the decisions are not the risk takers and have no incentive to be prudent decision makers.
Lets face it, if you are allowed to gamble with someone else’s money and are allowed to keep a high percentage of the winnings while getting paid for doing the gambling if there are losses, why wouldn’t you make the riskiest bets. In fact, looking out for your own self interest, you’d be dumb not to take inordinate risks. For you it is a win-win situation.
1 comment:
Great analogy at the end you're right if they're gambling with our money the shareholders there is no financial pressure to the ceo's against making the risky decisions. It provides them with the opportunity to gain immense reward if the investment turns out to be a good gamble, but they take their seperation package and get the hell out of Dodge if the gamble turns sour. Isn't there any laws that can enforce punitive damages or penalties for these companies that act so unethical with people money? Or at least some way to inform potential stockholders of these incentives before they purchase stock?
Scott Reese macroeconomics class
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