Bank managers as hired hands
March 1, 2012
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Hyman Minsky has this beautiful description of the seeds of any banking crisis in his 1986 book Stabilizing an Unstable Economy. It is worth quoting in verbatim:
BANK MANAGEMENT MOTIVATION
The typical professional bank president is not a rich man when he starts his career. As a bank president he is a hired hand trying to achieve personal fortune. But given the tax structure, it is difficult to accumulate a fortune by saving out of income; the most efficient route for a business executive is by way of stock options and the capital gains the accrue as the stock market price per share rises. As holders of stock options, bank management is interested in the price, on the exchanges, of their bank’s shares.
The price of any stock is related to earnings per share, the capitalization rate on earnings of the bank’s perceived risk class, and the expected rate of growth of such earnings. If bank management can accelerate the growth rate of earnings by increasing leverage without a decrease in the perceived security and safety of the bank’s earning, then the price of share will rise because both earnings and the capitalization rate on earnings that reflects growth expectations rise. In a capitalist society with institutionalized organizations and tax laws such as ours, fortune-seeking by the mangers leads to an emphasis upon growth, which in turn leads to efforts to increase leverage. But increased leverage by banks and ordinary firms decreases the safety of margin and thus increases the potential for instability of the economy. [Minsky, 1986, p. 266]
And please note that this was written in 1982 (!) (the book was published in 1986). Martin Wolf has rightly described it as a masterpiece that provide the incomparably best account of the last financial crisis.
What to do?
Minsky noted that:
To control the disruptive influence that emanates from banking, it is necessary to set limits upon permissible leverage rations and to constrain the growth of bank equity to a rate that is compatible with noninflationary economic growth. This principle should guide policy, but in an economy in which new financial usages and institutions appear in response to profit opportunities, it is a principle that is much easier to state than to translate into practice. [ibid, p. 272] Indeed!