Friday, 27 March 2009

Incentives matter: Geithner toxic asset plan file

The Streetwise Professor looks at the incentives in the Geithner Toxic Asset plan.
But it is well known that insolvent banks, or banks teetering on the brink of insolvency, face extremely perverse incentives. Shareholder and manager maximization for such institutions is often at odds with efficiency, and wealth maximization. This is true because managers and shareholders of troubled financial institutions have incentives to take unwarranted risks and invest in projects that dissipate wealth. That is, zombie banks (or more accurately, their owners and managers) are living, breathing moral hazard problems. Maximization for them means minimization for us.

Options in the hands of people facing perverse incentives are usually very, very bad things. Sort of like matches, gasoline, and tinder in the hands of pyromaniacs in a lumberyard.

In the present instance, giving potentially insolvent or near insolvent banks options can be expected to exacerbate, rather than mitigate, the current financial crisis, and the ultimate cost to us as taxpayers and economic agents could be huge–and, in my view, is likely to be so.

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