To What Extent Was the Global Financial Crisis of 2007/08 Caused by Inappropriate Incentives - Essay Example

Probes into the 2007-08 global financial crisis have revealed that executive pay packs and bonuses as well as ‘casino’ banking practices may have contributed to the crisis. Understanding these practices in the context of the crisis requires an evaluation of the banking sector itself in the context of how incentives contribute to risk origination and transfer. While assessing the same, Prager notes that the misaligned incentives were the result of compensation systems predicated on short-term performances at the expense of long-term outcomes. Naturally, misaligned incentives are pervasive and are strong drivers of behaviours, which mean that whenever they flourish, the results can never be desirable. In the backdrop of the 2007-08 financial crisis, a number of studies and recommendations have explored the issue of executive compensation in relation to risk-adjusted performance, and the extent to which laxity in the former catalysed the crisis. Central to this discussion is the extent to which the long-term cumulative effects of misaligned incentives and ‘casino banking’ practices triggered endemic stress in the financial industry, eventually leading to the crisis.

An in-depth understanding of the manner in which misaligned incentives contributed to the crisis requires evaluating the link between incentive pay and risk-taking. A study by Drasic and Velinova shows that from a behavioural perspective, incentive pay tends to encourage herding, more so in the direction of risk-taking. More specifically, the study reveals that a convex-shaped performance evaluation tends to encourage risk-taking since it makes investment an asymmetric bet. Furthermore, high rewards often leads to a reward-approach analysis of events, which in turn makes one prone to risk-taking errors. Essentially, the major trigger of the crisis, the sub-prime mortgage crisis in the US and UK, is the fallibility of human behaviour, hence the need to analyze the results from a behavioural economics perspectives. Prior to the crisis, financial institutions across the US and UK compensated their executives with huge bonuses, an aspect that enhanced their risk-taking behaviours that culminated in to the crisis.

In the case of the UK, many have observed that the crisis was in part the result of inappropriate incentive structures that encouraged unconventional behaviours. Similarly, an inquiry into the collapse of Lehman Brothers, a U.S. financial institution revealed that it was in part the result of significant problems in its corporate governance, which were exacerbated by the huge compensations it advanced to its executives, most of which were based on short-term profits. A study by Gregg, Jewel and Tonks examining executive pay structures of FTSE350 companies in the UK revealed that compensation and bonuses increased substantially over the period 1994-2006, with the highest paid CEO in the financial sector recording a net increase equivalent to 131 percent. The prospects of even greater rewards made bankers venture more into risky practices, which means that financial institutions were largely free to operate within the confines of their lending capacities. With such freedom, business and bonus possibilities for bankers became limitless, at least perceptually, and financial institutions became loan processors, writing and selling risks at will in the form of cheap credits.

The desire for increased compensation following improved performance of the financial institution also led to the invention of shadow banking system characterised by the presence of financial intermediaries responsible for facilitating credit creation across global financial institution. Noteworthy is that such credit facilities are not subject to regulatory oversight, hence are largely unregulated. The accompanying off-balance sheet entities had relatively high leverage, with some institutions recording leverage rates of between 25 and 30, translating into a capital-asset ratio of 3-4 percent. The downside of this precarious practice is that any small decline in the value of their assets would result in a corresponding decline in their capital. Most institutions employed higher market, credit and liquidity risks without commensurate capital, an occurrence that catalyzed the subprime meltdown.

Secondly, the period spanning 2004 to 2006 saw an expansion in the housing market that made many financial institutions to advance more mortgages to potential homeowners and investors, the sales from which inspired extensive engagement of the executives based on lucrative returns. In retrospect, the real estate bubble defied comprehensive explanation based on income growth and population, hence can only be understood from the perspective of an external force such as the prospects of substantial benefits to executives for increased risk-taking. Most financial institutions thus accumulated more debts in the form of high mortgage default rates. The resulting high-debt to equity ratio made the institutions more susceptible to incentive pay problems hence were unable to execute their primary functions, that of intermediating between savers and borrowers.Normally, higher debts imply more service fees and hence short-term profitability. Prior to the crisis, most executives in the banking sector received higher-than-average incentives to as rewards on the debts, hence their engagement in more risky ventures.

Finally, most financial institutions, lulled into the prospective return on investments given the excellent credit ratings, doubled up as investors alongside being the originators and marketers of the mortgage-related investments churned out prior to the crisis. However, unlike conventional investors, the institutions in a bid to protect themselves, innovated the credit default swaps, CDS, which were insurance against adverse outcomes on the derivatives, including default. In addition to being immense, the derivatives market was heavily opaque with few actors having knowledge of the counterparty to the loans. However, the fact that the loans were short-term meant the potential existence of liquidity risks, yet many actors in the industry failed to assess its scope, in part due to the sweet allure of rewards thereof.

What we are observing in relation to the contribution of maligned incentives to executives in the banking sector has everything to do with their short-termism, propelled exclusively by the allure of increased short-term compensations. Short-termism or myopia refers to the tendency of managers, CEOs, asset managers, among others to show unusual preference to short-term returns while simultaneously ignoring long-term value creation as well as the firm’s fundamental value. Such bias arises when the chief decision makers perceive the prospects of huge returns on short-term investments, especially in terms of compensations, and subsequently ascribe to the same. The result of such practices is that firms opt to squeeze their expenses to values that allow them meet their target earnings, and might go as far as reducing their investment on research and development, thus eliminating the prospects of creating a future competitive advantage for the firm. With increased under-investment on projects with long-term payoff periods, patient capital grows quaint, increasing the chances of failure that catalysed the crisis.

As broached earlier, performance-based compensation increases the chances of disastrous results, especially when it fails to take into consideration long-term consequences. In financial services, the downsides of risk-taking tend to take a long time before they materialize, which may put many businesses at risk of failure. In the wake of the crisis and the subsequent realization of the contribution of maligned incentives to executives, economic analysts in the U.S. came up with the Dodd-Frank Wall Street Reforms as well as the Consumer Protection Act, both designed to regulate financial institutions. The acts, and in particular Dodd-Frank recommendations, significantly expands the reach of regulatory entities. The post-Dodd-Frank landscape designates non-bank institutions as systemically important financial institutions, SIFIs, and places them under the oversight of Federal Reserve Board. Consequently, the Fed has powers to implement prudential regulations targeting systemic risks, thus capable of eliminating the prospects of unconventional, runaway market behaviours as observed prior to the 2007-08 global financial crises.

The consumer protection act on the other hand introduces corporate governance provisions, such as the need for shareholder to approve compensation packages for executives. The act aims at preventing predatory mortgage lending, enhancing the clarity of paperwork associated with mortgages and reducing incentives derived by brokers from mortgages by directing buyers towards more expensive mortgages. The act essentially aims at improving consumer knowledge regarding the products offered in the financial markets, hence creating the capability to make informed choices. The push for such reforms came on the backdrop of the realization that most financial institutions took advantage of investor knowledge deficiency to avail expensive, low-return products, most of which they lost when the real estate market tanked at the onset the financial crisis.

In the UK, the initial steps towards curbing the calamitous effects of untamed practices in the financial and real estate industries began with a suggestion to split the Financial Services Authority into a Financial Conduct Authority and a Prudential Regulatory Authority, with the latter being under the supervision of the Bank of England. The FCA is responsible for ensuring optimum functionality within the markets and within the set standards of supervision, and at the same time offers prudential advice to firms not covered by the PRA. The PRA on the other hand is responsible for promoting safe/sound behaviours of banks, insurers and systematically important firms. The main objective behind splitting FSA is to establish tougher, judgement-oriented and intrusive supervisory styles to ensure that prudential supervision and business conduct/consumer protection exploit their inherent difference in operational cultures, much to the elimination of the flaws characteristic of the FSA that led to extensive market failures previously observed.

Finally, UK also introduced a Remuneration Code that aligns with the EU Capital Requirement Directive, whose principles stipulate the need to align remuneration structures with safe risk management practices. In addition, present in the code is the need to defer payments of incentives, though with claw-back provisions, over a number of years as well as the establishment of performance criteria related to long-term profitability. Simply put, the code aims to align risks and rewards, discourage excessive risk-taking and short-termism, encourages the adoption of effective risk-management practices and availing support to positive behaviours and appropriate cultural conducts. The code covers all banks within the UK, building societies and investment firms operating in the country as well as certain overseas investment firms as determined by the code. Its wide level coverage ensures that both parent and subsidiary undertakings of a given group lie within its principles, thus eliminating any chances of malpractices.

The debate on maligned incentives and the recommendations relating to financial management centers on banks and investment firms majorly because the two exhibit comparatively large scales of executive rewards and at the same time have been extensively linked to the crisis. In contrast with bank bosses who are often hidden behind the scenes, their counterparts in public companies are usually at the top of their respective organisations, hence easily identifiable. Furthermore, unlike other businesses, banks and investment institutions tend to incorporate executive bonuses as part of the costs of running the business prior to arriving at their profits. Additionally, bankers tend to take more, in terms of compensatory benefits, compared to what shareholders earn, an imbalance unique only to the industry and related investment institutions. The implication of this is that bankers are more likely to feel encouraged to take more risks with other people’s money since they have little at stake, hence the widespread criticism regarding their role in the crisis.

Remuneration packages in the financial sector seem to have contributed extensively to the financial crisis of 2007-08, not because of the relationship between pay and stock market performance, but rather through incentive tailored to coerce them into ensuring that the firm’s assets are as large as possible. The quest for large asset bases saw a tendency of movement towards shadow banking systems, debt accumulation resulting in high debt-to-equity ratios, short termism- the preference of short-term projects over long-term ones, and intentional subversion of regulatory procedures. Collectively, these practices prompted unstable market conditions that catalysed the collapse of such institutions as Lehman Brothers in the US and extensive stress for UK’s Nothern Rock Bank, prompting a global financial crisis. Studies show that bankers tend to earn comparatively more bonuses compared to executives of other companies, all of which are calculated as part of a firm’s operational expense, quite in contrast with the observed practices in other public companies. The prospects of improved bonuses based on enhanced asset positions of banks and investment institutions inherently results in the adoption of unconventional, industry-hurting practices, aspects that have been shown to be linked to poor long-term performances and hence financial meltdown.