Our submission to the Walker Review

Sir David Walker has been asked by the Chancellor to lead a review of corporate governance in the banking and finance sector.

Sam Robbins and I, for the Intellectual Business think tank, have co-written a submission to this review which examines the moral hazard created by limited liability, and how bounded rationality interferes with ordinary market discipline to create risks specific to the sector. One particular conclusion is that the principal-agency problem that has supposedly led to bankers taking advantage of their innocent shareholders is nonsense. In fact, the nature of bank equity holdings specifically encourages risk-taking, and bank executives who made high-risk investments were acting precisely how their shareholders wanted them to.

Interested readers are very welcome to download a copy of the document:

Download Walker Review submission

It's a little more dry and technical in tone than some postings here, but is intended to be quite readable. Your feedback would be welcome.


Don said…
"Bankers’ remuneration packages evolved to fulfil the needs of shareholders. Whilst much recent
commentary has revolved around the incorrectness of the incentive structures this created, we
argue that this was epiphenomenal, and ultimately caused by shareholder preferences. Shareholders
of banks consistently voted for the remuneration packages that were put in front of them. Longer
term remuneration packages (with “clawback” provisions for poor performance in later years) were
not previously implemented, as shareholders were not prepared to accept the possible loss of
personnel (and damage to shorter term returns) that would have resulted. Put another way, they
shared both the investment horizon and the moral hazard of the bankers they employed – counter
to the common perception that a principal-agency problem caused risk-taking distortions. We argue
that a change in the ownership structure of a bank, and a consequent change of risk preference,
would contribute to resolving the issue of banker remuneration, at the same time as resolving the
problem of excessive risk-taking."

I agree, and am saying the following about Ponzi Schemes here:

"I still believe that the best lobbyists for a Ponzi Scheme are the clients, many, if not all, of whom, are wealthy and well connected, with easy access to lawyers. After all, you have to go to these clients and say:

“We’d like to look into your investment, since you’re getting unnaturally high returns.”

The answer might well be:

“You don’t say. Fancy that. That’s what I’m paying this person for!”

Perhaps someone could look into what, if anything, clients said or did, during these years. "

But, look, the answer to this question could have already been answered by considering Ponzi Schemes. After all, if I'm an investor in a Ponzi Scheme, and I figure that out whilst no one else invested in it has, the savvy thing to do is for me to stay in the PS, reaping high returns, but be gradually, w/o causing much fuss, withdrawing my money. In fact, one can imagine hedge funds and mutual funds dedicated to identifying PSs, and then investing in them in such a way as I just postulated for a savvy investor. A kind of market timing. Of course, their portfolio would need to be secret.

In order to disallow this, a court can take back money from investors in a PS who exit early, and put management in jail. Conceptually, these are both "Clawbacks". Hence, clawbacks are a necessary part of any solution. As with monitoring for PSs, it can only be of limited use given the nature of the endeavor, which is to make money. In making money, human beings lose a large amount of common sense and skepticism.Period. What you make transparent, they will view differently. Quite frankly, this is why reading crime novels is such an excellent place to discover human behavior in the real world. To understand x, look at how people scam it.

Now, on Epiphenomenalism. As I understand it, this concept arose as a solution to the Mind-Body Problem. The solution being that the body is causal, whilst the mind is not. However, I believe the point is that the Mind cannot, ever, be causal. In other words, it's not simply a case of an incorrectly ascribed cause. Yet, that now seems to be the meaning. Whilst X seems to be the cause, it's really Y. But that's not the same thing as arguing that X can't be the cause. It's not in its nature to be a cause.

Also, you have to believe that there is a Mind-Body Problem that needs solving. If you don't, it's not a very useful concept.

Don the libertarian Democrat
Leigh Caldwell said…
Thanks for the comment Don, always interesting to hear your thoughts.

'epiphenomenal' was not meant in the mind-body sense but the causal sense: the first definition here rather than the second.

Very interesting point about Ponzi schemes and perhaps an insoluble paradox. More and more, economic phenomena remind me of the centipede game.

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