When the dust finally settles from our financial crisis and economic decline, historians will likely conclude that many of the central myths about what caused the crisis were dead-wrong. One myth that is sure to die is the idea that bankers knowingly took on too much risk because the compensation structure encouraged them to ‘bet the farm’ on mortgages.
The rapid collapse of marquee Wall Street investment banks where bonuses were huge and egos larger, led many to conclude that it was Wall Street’s risk-taking culture and perverse payday incentives that nearly destroyed our banking system. While that might be true in a couple of isolated pockets, it’s not an accurate picture of what happened. The crisis in the banking system began before Wall Street collapsed and continues after Wall Street has found its feet again.
What really crippled the banking system wasn’t an incentive problem. It was a knowledge problem. The difference is this: bad incentives encourage people who know an investment is risky to invest anyway; a lack of knowledge means that people took on risk without knowing they were doing it. Our crisis seems much more based on ignorance and mistakes than bad incentives.
“U.S. banks have been dying at the fastest rate since 1992, mainly because of bad loans they made,” the Wall Street Journal’s Robin Seidel writes in today’s paper. Similar thoughts are voiced by the New York Times’ Floyd Norris this morning.
Seidel goes on to describe how Guaranty Financial Group was crippled not by engaging in overly risky practices but because it bought highly rated, straightforward structured mortgage-backed securities. It lent to home builders. Both of these things were what it specialised in, it’s “core compenentcy,” as it’s CEO puts it. They didn’t buy subprime loans, and didn’t buy much of the super-toxic 2006 and 2007 loans.
They thought they would be safe. And they were wrong.
Economists tend to concentrate on the problems of incentives, in part because most economists are social-planners at heart, always looking for a technical fix to social problems. Critics of banks also tend to like the incentive fairy-tale because it points to an apparently easy solution. Both groups are confident that if we just turn the dials on the incentive machine, we can set ourselves right.
Knowledge problems, crises rooted in mistakes rather than incentives or outright fraud, are far more difficult to address. What can we do about the fact that many of the smartest people in finance weren’t smart enough to see the problems that would cripple their banks? Wish for people who were smarter still?
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