Let's talk some econ/finance ****

[Asher]

In practice, how do stockholders actually design their own incentive schemes? That's pure theory. In reality, do you honestly see that ever happening?

[Kuciwalker]

They don't really have the opportunity, since we've gone through multiple rounds of "executive pay is done wrong! the government needs to tell the corporations how to do it right" by now.

[Drogue]

I have no issue explaining this to people or having a debate about whether in this case the issue is bad enough to warrant intervention, but don't start trying to claim that people have no idea what they're talking about when it's you who hasn't understood what it is.

Are you an idiot, Drogue? That's exactly what you did to KH.

And it's not a case of "if the issue is bad enough to warrant intervention", IT CAN'T POSSIBLY BE BECAUSE IF IT WERE THAT BAD PEOPLE WOULD JUST NOT LEND MONEY.

Moral hazard and externalities are distinct concepts: one is avoidable and one is not.

Oh dear. They are distinct concepts, but moral hazards still cause externalities. Both are fixable, but neither are avoidable. In fact, if you fix the externalities caused by moral hazard, you no longer have a moral hazard.

As for 'if it were so bad people wouldn't lend money', that's just a ridiculous statement. It can be bad enough to warrant intervention without being bad enough that the whole market falls apart.

I didn't try to claim KH had no idea, he had some great ideas, as I said. He just wasn't right on the definition of an externality or why this is a problem, just as you're not.

Bonuses for Wall Street wasn't the main reason the crisis happened (I would argue), but incentives to take risk did exacerbate it and cause problems. Size doesn't matter at all to me, but making sure that compensation is aligned with risk-adjusted performance and internalises the externalities taking risk imposes is a significant step towards making banking safer and crises less likely, without much economic cost.

Or we could let the ****ing stockholders design their own incentive schemes, since they have every incentive to do so. And lenders have every incentive to price the moral hazard into their bond purchases. Given your belief in the importance of incentives, what is the case for government regulation again?

You can't price moral hazard, if you could, it wouldn't be an issue. Plus, as I said, the government is the lender of last resort, taking on risk that it's not compensated for.

[Kuciwalker]

You can't price moral hazard, if you could, it wouldn't be an issue.

Of course you can. Insurance companies do it every single time they set rates.

[Kuciwalker]

Drogue, your definition of externality is both absurd and useless. The mechanism of Drogue-externalities through moral hazard and everyone-else-externalities are totally separate; Drogue-externalities are already disincentivized through reputation, and are communicated through price signals; Drogue-externalities can only be suffered by those who willingly accept payment in return for accepting that risk, whereas everyone-else-externalities are not compensated before or after the fact.

[KrazyHorse]

I have no issue explaining this to people or having a debate about whether in this case the issue is bad enough to warrant intervention, but don't start trying to claim that people have no idea what they're talking about when it's you who hasn't understood what it is.

Are you an idiot, Drogue? That's exactly what you did to KH.

And it's not a case of "if the issue is bad enough to warrant intervention", IT CAN'T POSSIBLY BE BECAUSE IF IT WERE THAT BAD PEOPLE WOULD JUST NOT LEND MONEY.

Moral hazard and externalities are distinct concepts: one is avoidable and one is not.

The market failure due to moral hazard would in fact occur if people refused to lend money to banks because of it. In fact, we only saw this market seize up due to uncertainty over previous decisions, not due to fear of future decisions.

The only reasonable externality argument lies between banks and taxpayers (assuming the political process is either unable or unwilling to resist insuring the liabilities of banks in whole or in part) or between various types of banks via the FDIC. As has been discussed, the taxpayer externality appears to be zero (or negative) due to the government's ability to affect nominal variables. The externality imposed by smaller banks on larger ones has very little to do with wall street comp schemes. Regulations against trading out risk obviously exacerbate this externality as well as the associated moral hazard issue.

[Drogue]

You can't price moral hazard, if you could, it wouldn't be an issue.

Of course you can. Insurance companies do it every single time they set rates.

That's not pricing moral hazard, they go some way to solve the problem by only selling partial insurance and adding requirements to be able to claim, and then price on a probabistic basis. The only way to price moral hazard is to attach an extra charge if you act in a riskier way than expected and a lesser charge if you act in less risky manner - a charge after they've chosen their level of risk. This would be possible to do if you could change the price you charge to lend money to them as and when they change their risk level, but bondholders can't do that, nor would they have the information to accurately measure the risk taken, nor would they be able to change employee remuneration and incentives. But most of all, they have little incentive to, since they're pretty much guaranteed.

Drogue, your definition of externality is both absurd and useless.

It's the same definition you posted, and it's the only way it makes sense to. I suspect our difference comes from the point above - if you could price it, there would be no externality to internalise. Because you can't price it, choosing to raise the level of risk, when this affects someone else, is imposing an externality on them, just as choosing to build a wall and block someone's view imposes an externality on them.

Anyways, I've lost any interest in explaining definitions, especially as it's a bit of a periphery to the actual issue - since bondholders in large banks are guaranteed, risk imposes a clear externality on the lender of last resort who gives that guarantee. That's the rationale to intervene. I'm sure there are ways the government could price this and move the price as the regulator assesses risk, though that's pretty difficult.

[Kuciwalker]

That's not pricing moral hazard, they go some way to solve the problem by only selling partial insurance and adding requirements to be able to claim, and then price on a probabistic basis. The only way to price moral hazard is to attach an extra charge if you act in a riskier way than expected and a lesser charge if you act in less risky manner - a charge after they've chosen their level of risk.

No, the moral hazard is priced ex ante. Just like all kinds of uncertain future events are priced into all kinds of asset values.

[KrazyHorse]

Drogue has fallen prey to definitional confusion, I think. Externalities as classically defined cry out for intervention because they lead to an unpriced consequence of an activity. If you attempt to shoehorn the costs to lenders of borrowers' activities then you lose the direct tie in. If this is the only consideration, then lenders will constrain at the very least the size of the lenders by charging them for the implied future costs. Instead of making himself look like more of a fool than he already has, he should move on to a less indefensible position

[Kuciwalker]

In practice, how do stockholders actually design their own incentive schemes? That's pure theory. In reality, do you honestly see that ever happening?

How about the government come up with a proposal for better executive compensation, and then have every corporation submit it to a shareholder vote to see if they want to try it?

But no, they would never consider letting any shareholders opt out of the government's "protection".

[Jon Miller]

Just like they don't let shareholders opt out of the governments requirements about discrimination.

JM

[Asher]

I don't even know why salary/bonus structure is a big deal. Yes, they are obscene at banks.

The reason the banking crisis happened in the US is largely just because the banks overextended themselves. They kept playing with money they didn't actually have. Canada had regulations to protect against this (20:1 max, IIRC...while Lehman was pushing 40, and BoA 30?). The US also had a critical failure in regulating their mortgage sector, which is another core cause of the failure.

The reason people were upset about the banking compensation is the people getting them were obviously inept. And don't tell me they weren't -- look at what they did to the companies.

Really, it's the wrong context to wag your finger at government regulation when the lack of government regulation is what got you in this mess.

[Kuciwalker]

Just like they don't let shareholders opt out of the governments requirements about discrimination.

JM

Government requirements about discrimination aren't justified on the basis of "protecting the shareholders". Restrictions on executive compensation are.

[KrazyHorse]

QJM, discrimination laws at least in theory protect those discriminated against, not shareholders...

[Jon Miller]

I have a question.

Why are bonuses preferable to salary?

Wouldn't salary encourage people who add long term to the company, while bonuses encourage people who add 'short term' to the company? (in which case, the long term could be negative even?)

I have often heard that the difference between the way that US firms work and other firms around the world work is that US firms are often much more focused on turning over a profit in the short term. There also seems to be a big pay difference between the CEO/banker types in the US and CEO/banker types in other nations.

JM