Managing The Financial Services Industry

This piece was originally inspired by a Financial Times OpEd article by one of my favorite authors, Nassem Taleb.  Taleb has gained a good deal of notoriety over the past year for his overt criticism of the financial services industry.  Perhaps the biggest problem for any public corporation is the misalignment of objectives between the firm’s agents (management team) and the firm’s long-term viability.  Because salary, bonuses, and incentives are awarded on a yearly basis, management’s goals become short-sighted.  In that same vein, too often incentives are not coupled with disincentives.  Managers who made millions riding the wave of 2003-2007 are not returning their salaries from those phantom profits.  Taleb put it best when he states that we are a country that ‘privatizes our gains and socializes our losses’.

While the idea of stock options was put in place to combat such problems, competitive strains show a manager who allows his company to fall behind when times are good will often not last long enough to see such prudence rewarded.  However, to take that idea one step further, a lack of delayed gratification on management’s behalf may ultimately fall on the shoulder of shareholders.  After all, who wasn’t pulling their money from elsewhere and piling it into the financials sector as the mortgage market exploded?

Taleb goes on to argue that in other professions (military) and other countries (Japan), there are other incentives (specifically honor) that can effectively motivate people.  While a pleasant thought, I continue to think money has to be the determinate in the workforce.  So it would seem to me that the only way to combat this inherent misalignment of interests and protect a company’s owners (shareholders) would be with effective regulation.  The problem in all of this was not corporate greed (greed is good), but a lack of regulation of that greed.  However, proposing regulation as the solution is almost painful for someone who traditionally holds a more libertarian viewpoint.  I do not think our regulators (because of their inherent political nature) are able to effectively regulate the financial services industry (or most any industry).  Unfortunately even effective policy making by the Federal Reserve is hopeless if regulation is not carried throughout the system.  Therefore, I sadly do not come to any sort of conclusion; just outline what I see as the inherent problem in corporate governance.

Consumer Excess

Taking the above idea one step further, it is interesting to analyze the problem from the second agent of the financial crisis; the individual.  Undoubtedly much of the blame for today’s crisis has to be placed on the individual consumer.  Theoretically the misalignment of an individual’s interest should be nonexistent.  Individuals are ‘compensated’ over the course of their lives; the agent is also the principle.  Therefore, the largess of the American consumer over the past ten years (which in the end drove the speculation in many of the problem markets) is inherently different from that which drove corporations’.

When Alan Greenspan cut rates to 1% in 2003, the idea was much the same as today.  He wanted to stimulate economic growth (via liquidity) following the tech crash.  Unique to the policy in 2003, however, was an increased focus on cheaper access to credit for borrowers who traditionally were unable to obtain financing for housing.  Fannie Mae’s affordable housing and home improvement lending programs created a new market of Alt-A and subprime mortgages.  This initiative led to the first problem at the consumer level.  Arguably (and in my opinion) those qualifying for these Alt-A and subprime loans were often not of an education level to make an informed decision about its future implications.  However, when money is available to you (from managers trying to keep pace/lacked regulation), it seems silly to turn it away.  The idea that credit for housing should be available to all Americans clearly (though sadly) needs to be reexamined.

The second driving force of the crisis at the individual level relates more generally to the entire class of consumers.  The inherent desire (perhaps greed is a better word) to live beyond our means created an environment of leveraged excess at the consumer level.  The bottom line in all this financial clamor is that the standard of living must come down.  A difficult reality as we have grown accustomed to certain luxuries over the past ten years.  It seems obvious to me that most in the top tax brackets now having their tax breaks cut by the stimulus package ended up there through fiscal responsibility and sound decision making.  The biggest shame in all of this may be that those who did live responsibly within their means are largely going to pay for those guilty of the excesses.  The inevitable result of a taxpayer funded bailout…

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