Organizational failure

Steve Randy Waldman has a good critique of Tyler Cowen’s view that the financial crisis is due to a downward revision of overly optimistic estimations of our wealth.
I agree. If the boom had been due to people in general believing they were richer than they were, we’d have seen soaring share prices and a boom in capital spending in the mid-00s, as we did during the tech bubble. But we didn’t. Instead,  as Steve says, the problem was not generalized over-optimism but rather a specific one, confined to banks.
Steve blames this on bad incentives. I’m not sure this is the whole story. For one thing, in the UK at least, it seems that the pay of banks’ bosses was not out of line (pdf) with that of bosses generally, suggesting that, in one respect, there was nothing unusual about bankers’ incentives. And for another, insofar as incentives were wrong, they had been wrong for years. So why did banks collapse in the late 00s, rather than earlier?
Here’s a theory. It’s to do with organizational brittleness. Here are some background principles:
- The death rate for firms generally is high. Of the UK’s biggest employers in 1907, only three are still independent, stock market-listed companies today.
- Companies embody specific vintages of organizational capital. Their expertise depends upon the state of technology when they were formed. It’s rare for a firm to transform itself from one activity to a completely different one; Nokia, which used to be a cable firm, is a rare exception - and a less healthy one than it seemed a few years ago.
- Because organizational capital is fixed, firms have “very limited capacities to acquire knowledge (pdf).” Rather than adapting to new conditions, firms die.
And here’s the thing. Banking changed in the 00s, in such a way as to render the vintage organizational capital of many banks obsolete, and thus to kill them.
Traditionally, banking consisted of getting deposits from savers and lending them to home buyers and companies. But in the 00s, this changed. Savings came not from UK and US households, but from Asians who wanted AAA bonds. This meant that many banks’ traditional business models were useless. They had to use wholesale funding, collateralized against manufactured securities, rather than merely domestic deposits. And this required that, rather than judge credit risk, in which they had some experience, they had to judge liquidity risk - in which, we know now, they were (even) less expert. It is no accident that the two “UK” banks to have done best during the crisis - HSBC and Standard Chartered - happened to be banks whose vintage capital gave them the ability to attract Asian deposits.
The banking crisis, then, was an example of a general corporate problem - the same sort of thing that killed Tower Records, Borders, Polaroid and countless others - an inability to adapt their business model to market and technical change.
I say all this because this story doesn’t fit comfortably into a Keynes vs. Hayek-style debate. It’s awkward for Keynesians because the story here isn’t an orthodox one of market failure, but rather of organizational failure - and a failure of organizations run from the top-down, which is what many statist Keynesians admire.
On the other hand, though, it’s awkward for Hayekians, because the message of the crisis and subsequent recession is that markets - actually existing ones rather than the textbook fairy tales - cannot smoothly absorb the failure of big organizations. 

Comments

[Stephen]

That's a good insight. But in support of the Hayekians, I'd argue that the severity of the collapse was exacerbated by the over-regulation of the banking system. If the banking market had been more like a free market, newer and nimbler entrants would have taken over from the older dinosaurs, thus avoiding much of the disruption. (Smartphone customers are not much inconvenienced by the collapse of Nokia and RIM, because of HTC and Apple.) But because the regulatory barriers to new entrants in banking are so high, we're stuck with the incumbents as they thrash around, trying to get to grips with the new environment.

[Alistair Mackenzie]

Stephen - seriously lack of regulation was the problem(!)
Surely the capital requirements and anti trust actions of the existing banks has much more to do with this.
Also free markets only really work if there are multiple competitors, free markets can easily tend to monopoly left by themselves.

Not sure that Keynsians are as statist as you imply either. This was the application of Keynesian policies that was in fashion between the war and the eighties but not the whole story.

[william]

Not sure if I buy the report.

Let's consider one of the claims: that excessive risk-taking was a cause of the crisis and it wasn't dealt with properly by regulators. But why take excessive risks? If there is no upside, in the form of increased returns to individual traders, what is the point? Do they just like living dangerously with other people's money?

No - the problem was not so much with executive rewards in banking (and the fact that they are as ridiculous as in other industries does not excuse them), but with rewards for traders.

In addition, their regression uses comparative performance (CompPerformance) which, if grossly exaggerated by the banks prior to their subsequent fall, would suggest that executive pay _is_ out of line with other sectors.

[Cahal]

The Keynesian analysis of the crisis is that interest rates were actually too high, and - when combined with lack of regulation - this spawned CDOs and so forth. Keynes also advocated banning loans to speculators.

I also dispute there was a global savings glut argument you appear to be making (?) The average global savings rate over the 24 years ending in 2008 was 23%. It rose in 2004 to 24.9%. and fell to 23% the following year.

However, I agree with you about the management issue. You had massive institutions, with management who simply had no idea what was going on.

Small groups of traders who were basically the only ones that supposedly understood what was going on were essentially unanswerable to anyone. They often operated for their own profit at their firms expense.

Yves Smith's ECONNED has excellent detail on this process. Apologies for my slightly incoherent ramble.

[Keith]

In reply to Stephen I think the Banking crisis shows great flexibility at work. Profit driven bosses wanting to make obscene gains that most people cannot even dream about decided to let equally greedy traders operate with total unaccountability and secrecy in a way impossible in a more structured bureaucratic system. It is profit seeking flexibility that makes this possible. One down side of this is that the whole world economy is in danger when secret unaccountable innovation operates with no imput from the wider society affected by this. The world economy is like a feudal system before Parliament is invented. Most of the people affected have no right to be consulted on the decisions that may ruin their lives.

[Phil]

To be fair, Lloyds TSB were doing fine until Victor Blank got his tap on the shoulder from Gordon Brown - the current share price is largely the work of HBoS, by which I mean BoS. (The Halifax operation is probably the biggest victim in all this.) But this doesn't go against your argument, as Lloyds had a name for being rather boringly conservative and sticking to what it knew.

[gclub]

Good day! this is one of the most interested statement I have heard anyone said. I have always say to myself there are no rules telling us what to do, but rules telling us what not to do. We need to start making rules telling us what to do and we will see how creative our world would be. thanks,