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The Role of Bank Managers in the World Financial Crisis

DiscussEconomics is happy to welcome Tamara Todorova, Associate Professor of Economics, at the American University in Bulgaria. Here is her article.

The Role of Bank Managers in the World Financial Crisis

In the havoc of the world financial crisis various explanations are provided in an attempt to try to curb it and avoid similar crises in the future. The crisis is now global but it started from the US and some economists search for the reasons in the US economy. To them the main reason for the crisis lies in the dramatic structural adjustments the US economy is undergoing and the spectacular shifts in the US real sector. In the last several years just on the eve of the crisis the US has exported an enormous number of jobs to countries like China and India without accommodating further for that loss of jobs. Without protectionist measures many sectors in the US economy have faced a decline which has further led to the impossibility of those employed in them to serve their credits and mortgages. The result has been their massive defaults and the follow-up wave of bank runs.

Others blame the excessive competition in the banking sector that stimulated banks to extend too much credit. Indeed, credit expansion in many countries suffering now from the world financial crisis had in the last several years reached an unprecedented high. Economists though have not credibly explained the reasons behind this dramatic credit expansion worldwide. The fact that there has been too much competition in the banking sector has led many to think that when markets are too free, they are not good or even that capitalism should be abolished and in its place a Marxist type of an economy should come, an attempt that has already proven to be unsuccessful.

Clearly, regulation on the part of the government was not adequate. Not that it was missing but perhaps it was not of the right type and timeliness. Yet, it is another factor contributing to the world financial crisis. In important and turbulent areas such as banking and finance government intervention may be more necessary than elsewhere.

A good number of observers and experts attribute the financial crisis to the gurus of finance who have developed sophisticated financial instruments where banks and financial institutions packaged their debt and resold it to others which on their part resold it to others in a chain mechanism perhaps designed to transfer one’s risk onto someone else. Even experts in the field find some of those sophisticated financial derivatives hard to comprehend.

All those might be possible explanations for the world financial crisis and probably all of them stimulated it in a concerted way. However, the main reason for the crisis seems to be no one else but the managers of all the banking and financial institutions involved. While the factors described above might be analyzed further, they appear to just be the symptoms of behaviour so wrong it has provoked the most serious crisis the world has seen in the last century after the Great Depression.

One could first ask why banks would give credit so vehemently when the long-term sustainability of such an action might be dubious. Well, the answer is that bank managers rarely have long-term incentives – their goals are more often than not short term. This leads to the standard principal-agent problem where the interests of the principal and the agents diverge. In the context of banks the principals are the owners and creditors of the bank who have a vested interest in maximizing the present value of their bank. Bank shareholders thus have the long-term goal of creating a solid and stable institution. The principal is generally interested in the reputation of his firm or value of his property since he would receive a continuous stream of incomes reaping the fruits of that reputation but reputation takes time to build. The numerous depositors in the banks generally also aim the long-term health and stability of the bank. Depositors, for the most part, also have long-term incentives – stable banks provide them with continuous returns on long-term deposits but even if a depositor makes a short-term deposit he would still be worried, if his bank or the entire banking system is shaky.

Well, in contrast to them bank managers usually have short-term horizons and goals often conflicting with those of their principals. What bank managers as the agents try to maximize is their own wealth and this usually is a short-term incentive. By excessively giving out credit bank manager actually create money and increase money supply. This process known in economic theory as the money multiplier is a successful tool for bank managers to enrich themselves at the expense of everybody else in the economy. By increasing money supply banks cause a dramatic increase in aggregate demand. Increased aggregate demand further pumps up the real estate or other bubbles, pushing up prices and making the respective industry highly profitable in the short run. The simple economic principle is that demand without money is no demand and that someone’s desire to buy becomes real demand only when backed with income. The availability of funds thus creates true demand and drives people’s desire to own expensive houses and luxuries, which otherwise they would not be able to afford. Without money in their pockets ordinary consumers would not be tempted to buy or undertake such costly projects. The desire to own a flat plus the ability to pay is what constitutes the demand in the housing market and makes it look highly profitable and attractive to invest in. Stimulated prices make investment projects look highly profitable but that is exactly what bank manager’s bonuses depend on. Bank managers’ remuneration and bonuses depend on the short-term profitability of investment projects, not on their long-term sustainability. Long term most of these projects would look like a failure. However, their short-term returns, given the money multiplier process, are extremely high.
In view of the real estate bubble one can easily see that bank managers have intentionally stimulated demand in the housing sector to make it a high-yield industry. Clearly, those investments would be unsound in the long run with the adverse effects of overconstruction but bank managers are not truly interested in the long-run soundness of investments of that type.

Various bank experts and employees nowadays blame the crisis on the bubble that arose in the real estate sector. What they do not say is that the bubble would not have arisen without bank participation and that behind that participation are bank managers. Bank managers, in fact, have for the most part caused the bubble – whether in real estate or elsewhere. As previously mentioned, without real money in their hands consumers would rarely be able to buy property so a bubble will be unlikely to emerge.

In their goal to maximize their own utility bank managers have benefited greatly from the phenomena taking place in the last several years in many economies across the world. Numerous data show the excessively high salaries and bonuses received in the various banks in the last years. The Chase Manhattan bank has been reported with an average yearly salary of nearly $500,000 for 2007 in its London office counting the janitors and the secretaries. Similar numbers could be found for all the failing banks and many of those still alive. But while salaries are not directly related to the returns of investment decisions, bonuses are entirely driven by the profitability of those projects and it is short-term profitability that affects the bonuses. Thus bank managers have the incentive to stimulate yields in the short run, not in the long run. The housing and other consumer-oriented sectors are the most suitable areas to achieve such short-term profitability.

Whether in the US, Bulgaria or Britain the scheme is the same – the bonuses received by bankers depend on the short-term profits of banks. And everywhere the same trends or patterns confirm the hypothesis that bank managers caused the world financial crisis that now has repercussions on the global economy and threatens to turn into a global economic crisis. In all of the failing banks in the affected countries bank managers gave out credits to people without income or with irregular, uncertain income. Unlike responsible decision-makers would do, they rarely did the necessary investigation as to how reliable the prospective debtor is, what his probability of defaulting is, etc. Diverse examples of credits with “favourable conditions” exist – low-interest credits, interest-only credits, exempt periods, credits without proof of income or origin of income, credits without collateral or credits for which the collateral is the real estate property itself. And nearly in each country the housing bubble was the mechanism behind bank failures – from the US to Germany to Belgium.

Bankers know portfolio theory well – every good finance textbook says you should diversify and not put all your eggs in the same basket. In the context of the real estate bubble this means that no matter how attractive the housing market is you should not invest only in real estate. Prices go down just as well as they go up and there is nothing more normal of prices to move both ways, not just up. Hence, bank managers have known very well that there will be a limit to this growth and that just like prices of real estate could go up, so they could start going down. But instead of giving credit to other businesses, as good portfolio theory would dictate or as the bank’s safety and stability would require, they would heavily put “their eggs” in the real estate basket only. Why? Because the real estate basket is the one in which profits could skyrocket most quickly short-term and the bank managers thus could extract the greatest amount of wealth. In the banks’ investment decisions therefore other areas of production or services would be greatly ignored and most of the banks’ capital would go into construction, a business whose long-run credibility and prospects are somewhat unclear. This again shows the bankers’ incentives to maximize their own wealth rather than ensure the bank’s health or represent the interests of the principal.
The sophistication of financial instruments also confirms the fraud that took place in the banking sector – risky debt with the possibility of high returns was issued so that high salaries and bonuses be received, then this debt was restructured and resold to others in a chain mechanism where the risk of chain failures was ignored although even little children could easily foresee this domino effect.

We should stress though that while bank managers’ behaviour was the trigger for the world financial crisis, there have been plenty of factors favoring this behaviour. Backed by government promises to keep the financial system secure and sustainable, bank managers have been frivolous to undertake highly volatile and risky projects that bring them immense perks. It is now common for the governments of western democracies to guarantee the safety of deposits to their full amount. Prime ministers often come out to calm the general public that their deposits would be ensured fully in case of bank runs and that bailout plans are the responsibility of the government. Furthermore, backed by the central bank as a lender of last resort the managers of commercial banks have inextricably followed a behaviour of moral hazard, the behaviour of an individual who, when insured, becomes more negligent and less cautious about the risks against which he is insured. In their own utility-maximization efforts bank managers have spread out the risks and the burden of the crisis over the general public, the ordinary taxpayers and the governments. They were in this led by their own greed, not by their concern about the collapse of the global financial system.

As to governments, it has long ago become obvious that they have not regulated banks enough. Governments have failed to steer the money-multiplier process and prevent inflation generation. In areas where such inflationary trends have been obvious and bubbles such as the real estate were about to burst, and where the need for government intervention with the tools of monetary policies or other has been pressing, no such actions have taken place. Governments could directly prevent the multiplier process by increasing the reserve requirement ratio or by manipulating equilibrium interest rates with the help of the discount rate. Anti-inflationary policies thus become the primary task of government economic policies nowadays. This is the course of action governments should pursue in general but mostly in periods of expanding bubbles. This governments should do in an attempt to avoid the growth of a bubble but also the formation of new bubbles. In an inflationary spiral one bubble often leads to another and causes a wave of rising prices in all sectors of the economy. For example, a dentist buying a flat more expensively would likely increase the price of his services, provoked by the increase in the purchase price of the flat and automatically transferring the bubble elsewhere.
A legitimate question to ask then is who the losers of this adverse behaviour are. Those are the very failing banks as credible institutions, their owners as well as their creditors, some of them losing their life savings. The government, in the face of the ordinary taxpayers, is another loser from the actions of bankers. Governments in the affected countries such as the US, Britain, Iceland, France, Germany, Belgium, etc. all have to adopt bailout plans to rescue what is left of the now insolvent institutions. But most importantly, it is the real sector and the economy in general who lose ultimately from the failure of the system. The financial crisis is already transforming into a recession making it harder for honest and essential businesses to borrow money, intensifying people’s pessimistic expectations and causing a major downturn in the global economy. With their irresponsible behaviour the managers of wealthy and reputable or what looked like reputable banks have created the conditions for one of the most staggering recessions seen in the modern global economy.

Well, whether as an ordinary depositor or a tax payer that will now bear the burden of the bank crisis, the ordinary citizen is the true victim of this downturn. Every member of society has firstly been a victim of the inflation generated by the banks. This has been most obvious to those who in recent years tried purchasing a house or similar property for themselves. On the real estate market people with good, secure and continuous income have had to compete with people with not so good, secure and continuous income. Honest, efficient and hard working individuals have been hurt by bubbles generated by the inflationary behaviour of banks and their officers. As a taxpayer each citizen is a victim and a loser since money that would otherwise go into productive public or private investment would now go into rescuing banks and financial institutions with questionable role in the economy. As a defaulting debtor the ordinary citizen is a victim, too. He will now face bankruptcy due to the upcoming recession, falling income and inability to pay off his debt.

Given the bankers’ incentive mechanisms and driving engines the world perhaps needs a more solidly founded banking system with stronger government participation and observance, one that follows the social interest and not that of an individual economic agent achievable at the expense of general economic efficiency and the stability of the global economy.

Tamara Todorova

Associate Professor of Economics
Department of Economics
American University in Bulgaria

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