PERVERSE INCENTIVES: RISK TAKING AND REFORMBanking & Financial Services Policy Report (2009)
AbstractThe common theme that ties the financial crisis (and this article) together is one of misguided incentives that pervaded the finance industry and perverted the actions of individuals and institutions resulting in a global crisis with severely deleterious social effects. In the world of finance, the greatest way to achieve a dramatic increase in wealth is to take large risks, of course, this is also the easiest way to lose it. A great deal of the so-called financial innovation that we experienced preceding the crisis was devoted to finding ways to take on as much risk as possible. The rise of off-balance sheet instruments, credit default swaps (CDS), and the spectacular risk-taking of individuals in the financial industry are all connected to the great rewards available through risk-taking. The first section of this article examines the incentives that encouraged financial institutions to assume as much risk as possible through the originate-to-distribute model and use of off-balance sheet instruments. It will then deal with financial compensation of industry members and how it encourages short-term risk. This section will conclude by arguing that the recent wave of government bailouts has created new mis-incentives, which, if left unaddressed, will create persistent market dysfunction. In the second section, we will investigate the often misunderstood and misrepresented CDS industry and how it has revolutionized the incentives of the financial industry. The mis-incentives pervading the finance industry caused complex financial instruments to thrive as they provided tremendous short-term gain while longer term risks were neglected. This article will examine how this behaviour is being reinforced by the government bailouts extended to the financial institutions most involved in accumulating extreme risk. As we go forward, it is imperative to realize that the government bailouts we are witnessing engenders a moral hazard by allowing institutions and their creditors to rely on government aid. Although this may be a necessary evil undertaken to prevent a total economic crash, the lessons of this crisis must be used to facilitate the evolution of the economy into a financial system in which private rewards and social returns are in alignment.
- Credit Default Swaps,
- Financial Reform,
Publication DateSpring June, 2009
Citation InformationAaron J. Unterman. "PERVERSE INCENTIVES: RISK TAKING AND REFORM" Banking & Financial Services Policy Report Vol. 28 (2009)
Available at: http://works.bepress.com/aaron_unterman/3/