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Sleepless in Fulham: Rambling and gambling by David Young
Friday, 13 February 2009
At the core of the problem.
Topic: Politics

A friend asked me to comment on something to do with the current economic mess. I wrote back about what I believed to be the core problem (with minor changes):

What I keep wondering is when the crunch will be explained to people in terms of the 'principal-agent' problem. By this I mean that banks incentivised their staff in a way that made poor lending rational and caution irrational. If you give someone a bonus this year for a lending decision that could cost the bank money several years AFTER the bonus has been paid, then you should not be surprised if he makes a lot of terrible loans. It would be irrational to expect otherwise. The employee doesn't lose his own money if the loans go wrong, but he gains from the bonus he earns from making the loan. He may not expect to still be working for you when loan defaults anyway.

The bizarre bit therefore is not the behaviour of the individual bankers, which was wholly rational, but the behaviour of those who owned shares in banks and failed to spot the fault line in the business model.

Once seen in this light, nationalisation appears less attractive because the same applies. Governments are elected on five year mandates at best, politicians have limited careers and aren't betting their own money. So the same risk of bad lending applies - just with political motivations instead of personal gain involved. Replacing blind faith in the City with blind faith in Westminster doesn't fix the problem. It's being blind to risk that's the issue.

_ DY at 1:59 AM GMT
Updated: Friday, 13 February 2009 2:04 AM GMT
Post Comment | View Comments (3) | Permalink

Sunday, 22 February 2009 - 11:38 AM GMT

Name: "anonymous"

If a betting shop offered bets with your money back if the horse fails to win then you would think the betting shop manager was mad.

And yet, banks offer employees the chance to double their money with risky decisions and even if their decisions are bad they still get their salary.

Sunday, 22 February 2009 - 12:37 PM GMT

Name: "David Young"

That's basically the point. Obvious, isn't it?

I remember thinking in 1995 that the mystery of the whole Nick Leeson affair wasn't that it happened at all, but that it didn't happen more often. I recall reading in the 80s about the so-called 'Acapulco Spread'. You did a big trade on a Friday and went to Acapulco for the weekend. If the market opened your way on Monday you flew back home. If it didn't, you stayed on holiday. 

If this problem was known about then, why did bank shareholders carry on funding this lunacy for so long?

In 2003 Panorama did an expose about the fraudulent use of self-cert mortgages. A wannabe borrower phoned a bank and was basically told over the phone that there would be no verification of his salary claims. In essence the person taking the call was colluding with the borrower to defraud shareholders (or future shareholders when the whole house of cards came tumbling down).

Tuesday, 24 February 2009 - 11:46 AM GMT

Name: "roGER"
Home Page:

"If this problem was known about then, why did bank shareholders carry on funding this lunacy for so long?"

Firstly, shareholders are often big institutional lenders who don't get involved in the details of day to day operations of the banks which they effectively own.

Secondly, and far more importantly, for well over a decade it seemed as if the banks could do no wrong, and hence "if it ain't broke, don't fix it."

As someone involved at the sharp end of private industry, including the odd bank and insurance company, for over 20 years, I can safely say I've never known the details of anyone remuneration except my own, and have never met or been asked a question by any shareholder...



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