Banking Crises can be found throughout history. Even if every crisis is unique, similarities can be found as well. This paper argues that flawed incentives have caused the current financial crisis and the Asian currency and financial crisis from 1997 to 1998.
Incentives, in the sense of this paper, can simply be defined as a motivation (monetary or non-monetary) to take certain actions. I.e., incentives are intend to encourage people to do more good things and less bad things. However, flawed incentives can lead to unexpected reactions of individuals in order to maximize their own gains.
In the following I am going to describe the most important aspects of both crises, including flawed incentives that have been in place to cause the crisis. Afterwards I give a personal statement and propose an outlook for the future of incentives.
The roots of the current financial crisis lie in the housing bubble. The banking system has suffered from the burst of the bubble for two main reasons: First, banks have been able to place assets in off-balance-sheet vehicles and hence did not have to hold capital buffers against them. Second, banks could lower their regulatory capital requirements by investing in “AAA”-rated securities, mainly mortgage-backs or related derivatives, what enables them to operate with higher leverage. Even if banks have been aware of the incorporated risk of this business, the existing incentive systems encouraged the traders to invest in these assets. Short-term cash bonuses based on sales volume rather than on long-term profitability, blinded bankers towards mismatches of financing long-term assets with short-term debt and liquidity risk. With the burst of the bubble, the banks had to deal with the real risk in and off their books, while the short-term bonuses are already paid out to the employees.
This short summary of the financial crisis shows that employees have been encouraged to “bet” on mortgage-back securities in order to maximize their own salary on a short-term basis, due to the fact that they will not be responsible for the long-term profitability of the bank or its risk position. As a result one could argue, that we still need to learn more about risk and how to incentivize managers and employees by lowering risk by simultaneously maximizing profits.
The Asian currency and financial crisis can be discussed in a similar manner, even though issues arose from another type of incentives. The Asian currency and financial crisis hit rapidly growing countries in the world and prompted the largest financial bailouts in history. Radelet and Sachs (1998) argue that the crisis was caused by a boom of international lending followed by a sudden withdrawal of funds because of raising panic.
To investigate the role of incentives for the burst of the “foreign lending bubble”, it is important to understand, why Asian banks attracted and accepted the extremely high money inflows. Asian countries, such as Malaysia and Indonesia, have been attractive to foreign investors due to the high interest rates. Several governments had incentives for banks in place, which encouraged lending in foreign currencies. For instance, banks operating in the Bangkok International Banking Facility (BIBF) received special tax breaks for borrowing and lending foreign currencies. Similar incentives could be found in the Philippines. Generated income form foreign exchange loans was not subject to the regular corporate income tax rate of 35%, instead banks have been subject to a tax rate of 10% for these profits. Additionally the banks were not facing any reserve requirements for foreign currency deposits. These two examples show that distinct incentive systems, set-up by governments, encouraged banks to seek for foreign investors, what finally caused the high amount of capital inflows in Asian countries, making these systems vulnerable to panic.
Another influencing factor during the Asian crisis have been incentives of controlling shareholders, in the mean of gaining profits, to expropriate minority shareholders. The large separation between cash flow ownership and control rights caused the ability and the incentive for insiders to expropriate small investors.
Finally, the Asian currency and financial crisis was also affected by inappropriate incentives. Governments introduced two main kinds of flawed incentives that went wrong. First, governments encouraged banks to engage more in foreign currency business by giving incentives such as lower corporate tax rates. Second, controlling shareholders gained incentives to expropriate minority shareholders due to incomplete agency regulations.
As we have seen for far, both crises have been caused in part of the existence of flawed incentives. The difference between both crises is the fact, that not the same groups created these incentives. In Asia, the flawed incentives can be found between the governments and the banks, i.e. on a macroeconomic level, while the flawed incentives during today’s crisis affect the microeconomic level, i.e. between the employer bank and its employees/managers.
My personal statement towards both kinds of flawed incentives, that I presented so far, is that serious problems can be caused by an incomplete or misleading setup of incentives. As we can learn from both crises, this applies to the company level as well as the state level, i.e. the microeconomic and macroeconomic level. Hence it is important to choose incentives wisely and to evaluate the supposed outcome on a regular basis. If the outcome of an evaluation shows that existing incentives cause not intended results, companies or governments should take effort to rearrange the underlying rules. It also shows that the incorporation of risk and a long-term orientation of profits should be more important for future incentive contracts. However, the understanding of risk and its combination within incentive contracts will be an ongoing issue throughout time. This is so because better risk models will reduce the cost of leading player. Following this, financial institutions will be enabled to create new financial products to maximize their profits. If incentives are not renegotiated to apply for these changes, it could be argued that the total risk level for banks will rise again.
Finally, incentive contracts are nearly impossible to be created in an accurate way, which follows the results of the agency theory. To prevent banking systems from crises, due to flawed incentives, the incentive contracts need to be evaluated on a more regular basis and have to account for existing as well as expected risks. This will lower the possibility of system failures, due to misinterpreted incentives. However, banking crises happen due to multiple influencing factors and are expected to happen again.