23 Feb 2010

Randy Kroszner On The Financial Crisis

I attended a lecture yesterday at the Chicago Booth London campus by Randall Kroszner, former member of the Board of Governors of the Fed Reserve. Randy is the Norman R. Bobins Professor of Economics at Chicago Booth and he spoke about his experiences during the financial crisis and his analysis of the causes and remedies. His talk will be up as a podcast/vidcast soon and I will share the link when it is up, but I found some of the Q&A (details below) especially fascinating:

Q. A Chicago alum now working with the FSA brought up the topic of issue of executive compensation in the financial services industry.

A. Kroszner's take was that the renewed attention to the issue is welcome but it might be a bit misfocused.

  • To build his case, first he quoted the example of Bear Sterns - even though most BS employees had their compensation in the form of stock, this did not prevent excessive risk -taking; at the end, they lost 99% of the value of their shares. So just moving a component of compensation to stock (long term) instead of cash (short term) may be too simplistic and not necessarily avert insensible risk-taking.
  • Secondly, he made the point that if you create a rule stating that "banks" cannot offer such compensation, it becomes a boundary issue - instead of a "bank", there will be some other body which will take up the risk for a suitable reward and so the boundaries (of which institutions take the risk) get redrawn but the systemic risk remains the same.
  • And finally, Randy said that it is in the interest of the state and the public to see these quasi-state owned banks (RBS/ Citi etc) perform well and make a profit to the stakeholders (ie the taxpaying public). When you impose an artificial limit on the compensation of employees in such firms, it's shooting yourself in the foot... you will not be able to hire the best talent in the industry because the best talent will be picked up by privately owned competitors who can pay them more... (My personal take: unless you have altruistically motivated geniuses who are willing to pass on the cars and the yachts and work to save these banks while taking flak from the government and the public - does anyone see that happening?)

Randy's conclusion was that while there is definitely a problem in the risk-reward alignment and while it is a popular perception that bankers are overpaid, the issue is a lot more nuanced and interconnected with systemic issues it appears to be.

Q. Can the West spend its way out of the recession?

A. "If something cannot go on forever, it will stop" - Herbert Stein. Randy made the case for a difference between spending that becomes a multiplier and spending that's pointless. If the stimulus spending was to improve the state of infrastructure or to repair the high school education system in the US, then it makes sense to invest because the returns will be manifold. On the other hand, if stimulus investments are spent on "porkers", then you're probably digging yourself deeper into a hole... acc. to Randy, the %age of the current stimulus package being spent on what he called "useful long term investments" was not at all encouraging.

Q. How did you feel in the heat of the crises - how did you make decisions etc? Were you scared? (not my question!)

A. Yes, he said, there was a heightened awareness of the immense impact of each decision but rather than fear he said that this created a very acute focus on the issue at hand. He quoted a favorite book of mine, The Lords of Finance and how it opens with Montagu Norman, the then Governor of the Bank of England going on a long holiday because he was stressed out... almost in the middle of the Depression. Would Bernanke be able to do this today? ;-) He stated two issues that he thinks made the difference:

  1. In the middle of a crisis when there are a hundred things flying all over the place, it is very important that you have an analytical framework in place... this framework helps you set aside emotional baggage and associated panic and points you in the right direction. It sets the context for what one needs to focus on and keeps you focused on that, or at least in his case
  2. It helped tremendously that 3 of the 9(?) Fed governors had done academic research on the causes and effects of previous Depressions/ Recessions. For example, they knew that in the panic of 1907, JP Morgan had the choice of either bailing out the Knickerbocker Trust or letting it fail as punishment for screwing up. When Morgan let it fail, it signalled the end of the private clearing house system and ushered in the Fed Reserve system. It was an analytically easy decision to let Bear Sterns fail for its transgressions... but as they knew from history, this could have become the first step in letting the Fed Reserve System fail and no one wanted that to happen.

These points were fascinating - for me, they illuminated the importance of having an analytical framework or viewpoint when going into a crisis. At the same time, it also highlighted the importance of learning the right lessons from history and not missing the link between cause and effect.

Thoroughly fascinating descriptions but I was a bit disappointed that there were no specific prescriptive stances that Randy took... especially with regard to executive compensation or bank regulation. Yes, the issues are very complex and sophisticated but it would have been great to hear him a stake on the ground with rules or assumptions that could form the basis of any future decisions.

UPDATE (23.Feb.2010): Penka Bergmann from the London campus just mailed and shared the podcast link - happy listening!

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