The ownership crisis redux

Many thanks to all of you who answered my question about banks’ risk managers (here and here).  The consensus seems to be that managers were rational and well-informed, but had incentives to take big risks.
But this only strengthens my view that the crisis is due to bad ownership structures.
The question is: why didn’t bank shareholders appreciate that big profits were due just to picking up pennies in front of a steam-roller, to use Taleb’s words, and so change managers' incentives?
There are two possibilities. One is that it is they who were stupid. The other is that they were smart, and dispersed ownership was the problem.
When a firm is owned by hundreds of people, no-one has an incentive to look after it properly - because the hassle of organizing with other shareholders to control or change the management outweighs the benefits of having a better-run company, as these are spread across everyone, including the free-riders who just sat back and did nothing.
Good management is a public good. And public goods get under-supplied when many individuals pursue their own interest.
Banks’ failures are therefore ownership failures.
In this context, this new paper is relevant. So far, the claim that dispersed ownership can be bad is founded in the experience of western banks. But Sanghoon Lee shows that it’s true in a different sample:

Using panel data for South Korea in 2000-2006, I find that firm performance measured by the accounting rate of return on assets generally improves as ownership concentration increases.

This raises a possibility. Could it be that big government ownership of banks might actually improve their performance, as the discipline provided by a concentrated shareholding - however dodgy that shareholder is - outweighs the costs of the ill-discipline fostered by dispersed shareholders?

Comments

[Bob B]

What I can't figure is what all those highly paid financial economists, with their MBAs and PhDs from prestigious unis, who are working for financial institutions on both sides of the Atlantic were doing. After all, as S&M has pointed out, it's been known for a while that investment yields don't have a Gaussian (normal) distribution and I came upon this from 2004:

"In the sixties Mandelbrot already showed that extreme price swings are more likely than some of us think or incorporate in our models. . . "
http://lstat.kuleuven.be/research/reports/2004/report2004_08.pdf

Why weren't alarm bells ringing?

[Will Davies]

Becker and Posner are chewing on something similar as well:
http://www.becker-posner-blog.com/archives/2008/10/the_financial_c_2.html

[Pete]

I don't think this is a co-ordinated action problem: there's an ownership problem BECAUSE the shareholders are stupid/uninformed.

If they know that management is "picking up pennies in front of a steamroller", they don'thave to organise to change the management, they can just sell up and buy into a better run company, or indeed stuff the money into their mattresses. Stock price plummets, management get jobs in McDonalds, tragedy of the commons avoided, no co-ordinated action required.

The fact that they didn't sell suggests that they thought management were doing a fine job.

I can see why concentrated ownership might help solve this, but I think it happens a level further down - at the level of working out what the hell the management is doing in the first place.

[Luis Enrique]

There are other potential elements to this story, that sit somewhere between stupidity, and the problems inherent in dispersed ownership. For example, to do with the complexity of the system, and to do with how people update their beliefs based on what they see others doing etc. These might mean that disasters like this are as likely under any ownership structure and that you might be placing too much emphasis on ownership.

Many people have mentioned that banks found it very difficult to resist participating in the (short term) money making, because it was very difficult to sit there saying "we're making less money than everyone else because we believe this is all going to blow-up, some day". Others have said that banks' behaviour created risks of the sort that occur when everyone goes tits up (the steam roller), because they believed that if that was ever to happen, they'd be collectively bailed out, rather than having to face individual failure.

I don't see how co-operatives, for example, would be less susceptible to this behaviour. Can you remind us what forms of ownership you think might have prevented this crisis?

[Adam]

The agency problem isn't between shareholder and director. The fund managers who are de facto shareholders in plcs have their remuneration based entirely on short term performance. What's even more worrying is that these fund managers are judged on their performance *relative to the market* so they have no incentive to look at systemic risk.

[Bob B]

I don't see it as all due to ownership issues.

Credit where it's due. Charles Goodhart was warning about the house-price bubble in Britain back in 2002:

"CHARLES GOODHART, a former member of the Bank of England's monetary policy committee, warned yesterday that the Bank is failing to take sufficient account of the house price boom in setting interest rates.

"His warning comes amid growing fears among economists that house prices, fuelled by the lowest interest rates for 38 years, are getting out of control. Yesterday, new figures showed that homeowners are borrowing record amounts against the rising value of their homes. . . "
http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2002/04/06/cngood06.xml

But then in December 2003, Gordon Brown as Chancellor, went and relaxed the inflation target remit to the Bank of England - against the advice of the Bank - by redefining the target in terms of the CPI instead of the RPIX, a more broadly based price index which included house prices when the CPI doesn't. According to the ONS, The two price indices since diverged until very recently:
http://www.statistics.gov.uk/cci/nugget.asp?ID=19

Had the inflation target stayed fixed on the RPIX, the Bank of England would have had to set higher interest rates. Of course, that would have been electorally unpopular in the run up to the general election in 2005.

[ChrisP]

The owners are actually 'rentiers' and they too only look as far as the next dividend cheque. But they have been left with something (even if sadly diminished)unlike the nothing that a normal hard-core capitalist solution offers. Therefore the lauded Brown solution is poor capitalism and even worse Marxism. Don't forget that it is not a systemic failure but is bank specific.

[David Heigham]

A year ago, when the size of the recapitalisation problem became evident, I rather hoped that a sovreign wealth fund would buy control of a major Western bank. My reasoning was that it would "behave like an owner (copyright W. Buffet)". One bank managed like that could produce some interesting competitive pressures on the others.

[Gerard O'Neill]

You may be right about the virtues of concentrated shareholdings. But it doesn't have to be government that does the shareholding. Deepak Lal has been saying for years that legislation inhibiting hostile takeovers (especially 'surprise' takeovers) gave insider managers every excuse to featherbed themselves at the expense of shareholders. There's nothing like the threat of a hostile takeover and a concrete parachute to keep risk-ignoring managers in check. http://www.business-standard.com/india/storypage.php?autono=326695

[Patrick]

Yes.

A CEO who is answerable to a thousand shareholders in actually answerable to nobody.

A CEO who has only two or three shareholders to appease has to be bloody careful.

[Jon B]

New to your blog - I think your identification of the structure of ownership as being a (not the) root cause is spot on. However on your final paragraph about government ownership - you could argue that this is the WORST form of ownership as the government, far from being a single rational entity, is in fact in turn "owned" by all of us, and so is the ultimate "dispersed" shareholder.

[PWG]

Big government ownership will be harmful to the banks. This is because the government have already said they want to use the banks to revitalise the housing market, through making more loans than the banks would want to make. Thus, a return to the irresponsible lending that got them into the mess.

[Bob B]

"I think your identification of the structure of ownership as being a (not the) root cause is spot on"

Welcome aboard.

I don't accept the diagnosis that ownership issues with the misspecification of incentives in principal-agent relations are at the root of the problem.

For a start, there was misinformation out there with rating agencies assigning higher ratings to assets than could be justified by fundamentals - possibly because the rating agencies were being commissioned by the very institutions issuing the assets:
http://www.ft.com/cms/s/0/a11edb08-8426-11dd-bf00-000077b07658,dwp_uuid=5fd271ee-61f6-11dc-bdf6-0000779fd2ac.html?nclick_check=1

It's worth reading Joe Stiglitz on the crisis:

"The new low in the financial crisis, which has prompted comparisons with the 1929 Wall Street crash, is the fruit of a pattern of dishonesty on the part of financial institutions, and incompetence on the part of policymakers."
http://www.guardian.co.uk/commentisfree/2008/sep/16/economics.wallstreet

Stiglitz has for long argued that market failure is inherent in financial markets - for reference, see his book: Whither Socialism? (MIT Press 1994) and eg "Credit Rationing in Markets with Imperfect Information", with A. Weiss, 1981, AER.

As for structure of ownership, there is the continuing puzzle as to why banks with head offices in northern places and Scotland were more vulnerable because of excessive reliance on borrowing in the wholesale money markets to finance expansion as compared with banks with head offices in London.

[Bob B]

Predictably, there will be a vast outpouring of books about all this. Some have already started to appear so I hope we will soon be reading reviews and surveys:

Brendan Brown: Bubbles in Credit and Currency (Palgrave, 2008)
George Cooper: The Origins of the Financial Crisis (Harriman House, 2008)
Jean-Charles Rochet: Why are there so many Banking Crises? (Princeton UP, 2008)
Robert Shiller: The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do about It (Princeton UP, 2008)

But I trust earlier contributions and precursors won't get overlooked:

Paul Krugman (ed): Currency Crises (University of Chicago Press, 2000)
Donald Campbell: Incentives: Motivation and the Economics of Information (Cambridge UP, 2nd ed 2006) - especially on moral hazard and the Federal Deposit Insurance scheme.
Charles Goodhart and Boris Hofmann: House Prices and the Macroeconomy (OUP, 2007)

[Joe the Plumber]

A former CEO believes the best way to compensate CEO's is with modest salaries and stock's held in escrow.

http://businesswisdom.blogspot.com/2008/10/ceos-reward.html

[Bob B]

Any comments about this - predictable - news?

"The head of the government's financial watchdog, Lord Adair Turner, has warned the City that the days of soft-touch regulation are over.

"In an interview with the Guardian, Turner warned that a new cadre of higher-paid regulators would ask tougher questions about the health of financial institutions in the wake of the credit crisis.

"Turner admitted that the Financial Service Authority had tried to regulate Britain's big banks 'on the cheap' in the past but that a new and more stringent regime was now on the way. . . "
http://www.guardian.co.uk/business/2008/oct/16/creditcrunch-marketturmoil