Economist's Notebook: Bank Regulation

Paul Krugman's latest is very good and echos what I consider the fundamental point about the banking crisis: the incentives to bankers was clear - get risky or die.  Okay, maybe it wasn't that extreme, but when banks are rewarding clients with high returns from practices that are questionable, and the demand for these assets are sky high, only the brave bankers settled for lower performance and lower risk.  And perhaps these conservative bankers were foolish in the end, even if they did make the right choice, in that the US government had their back anyway so they should have gone for the big rewards.  In the words of Robert Frank, when payoffs are linked more to relative performance than absolute performance the incentives are to take on more risk.  So it isn't enough to run a successful, well-managed bank, you have to bring it better returns than the other banks no matter what.

Mounting evidence shows that it was not the Community Reinvestment Act, not Fannie Mae and Freeddie Mac, not really all that much about exotic finance; but more about the pushing of mortgages on anybody and anything to get them out there so that exotic finance could take place.

Here is Krugman on the Irish case:

Ireland had none of the American right’s favorite villains: there was no Community Reinvestment Act, no Fannie Mae or Freddie Mac. More surprising, perhaps, was the unimportance of exotic finance: Ireland’s bust wasn’t a tale of collateralized debt obligations and credit default swaps; it was an old-fashioned, plain-vanilla case of excess, in which banks made big loans to questionable borrowers, and taxpayers ended up holding the bag.

The point is where there are clear strategic incentives to behave in an ever more risky fashion (you can't be the bank that doesn't do the risky assets because your performance will suffer and your share price will plummet) there has to be regulation to take the super-risky options off the table.  This is game theory 101.  Sadly, efforts to reform the financial sector appear to be dead in the water.  So be prepared to replay this record all over again.