The Financial Industry: Too Important to Leave to Bankers

“Banking, it would appear, is too important to leave entirely to bankers.”

In the wake of the financial crisis, regulators have undertaken critical steps to alter financial institutions’ appetite for excessive risk, culminating most notably in the Dodd-Frank legislation passed in 2010. In a recent Staff Report “Corporate Governance of Financial Institutions,” Federal Reserve Bank of New York analysts point to two new issues that, in the years ahead, should shape financial policy in this country: increased market discipline and improved financial product information.

Financial institutions, the authors contend, are still “frustratingly inscrutable” due to incentives to value-maximize, that is, to make the largest possible profit. But, the authors argue, banks should be evaluated based on the conflicting demands of safety and soundness, on one hand, and innovation and improvement, on the other. Financial markets are “too important to not work” for both firm and household credit.

If we lived in a world with perfect information and no market failures, the report says, the interests of shareholders and society would be one and the same. Since we don’t, the profitable opportunities for financial institutions often put the public and shareholders at odds. Shareholders want a higher level of risk-taking than does the public, and the “moral hazard” created by “too big to fail” government bailouts and deposit insurance benefits banks and shareholders at the expense of taxpayers.

There are two ways regulators can achieve the Fed’s policy recommendation of increasing information and market efficiency: (1) by mandating information through increased disclosure; and (2) by motivating information production by changing corporate governance incentives.

On top of annual and quarterly reports, financial institutions should be mandated to release their plans for orderly liquidation (so-called “living wills”) in the event of failure. Additionally, executive compensation should be tied to a bank’s credit quality. Cash bonuses based on profits encourage excessive risk-taking. A compensation scheme linking bonuses with credit availability and quality ties compensation to bank performance.

Finally, the report offers two additional recommendations to improve safety and soundness in the financial industry. First, policies to eliminate predatory lending increase both stability and efficiency. Second, improving debt and equity instruments – and pricing them in a way that does not reflect the upsides of risky behavior and the mitigating expectations of government bailout – will make financial markets more efficient.

As the Fed staff report surmises, the role of information in reducing market failure in the financial industry is critical. New regulations which mandate and incentivize the disclosure of information can benefit the public in the long run by discouraging the behavior that led to the Great Recession.