In the interest of keeping our eye on the ball in FinReg, let me present Alan Blinder stating that incentives in banks that are too big to fail simply must be totally and completely broken and misaligned:
I’d like to defend Raghu a little bit against the unremitting attack he is getting here for not being a sufficiently good Chicago economist and just emphasize the sentence in his paper which says, “There is typically less downside and more upside risk from generating investment returns.” This is very mildly said. The way a lot of these funds operate, you can become richer than Croesus on the upside, and on the downside you just get your salary. These are extremely convex returns. I’ve wondered for years why this is so. You don’t need to have public regulatory concerns to worry about it. Take the perspective from inside a big company. The traders don’t own the capital. The traders are taking all this risk and putting the company’s capital at enormous risk. I don’t quite understand why the incentives are as they are.
I remember a discussion I had with—I won’t name him—one of the principals of the LTCM, while it was riding high. He agreed with me that the skewed incentives are a problem. But they weren’t solving it, obviously. So far, that is just an internal problem to the firm. What can make it a systemic problem is herding, which Raghu mentioned, or bigness, which is related to the discussion that Fraga raised, and so on. If you are very close to the capital—for example, if the trader is the capitalist—then you have internalized the problem. So, it may be that bigness has a lot to do with whatever systemic concerns we have. Thus, I’d draw a distinction between the giant organizations and the smaller hedge funds. Whether that thinking leads to a regulatory cure, I don’t know. In other domains, we know, bigness has been dealt with in a regulatory way.