WASHINGTON (MNI) – The following is the third of five sections of
the text of Federal Reserve Chairman Ben Bernanke’s remarks prepared for
the Bendheim Center for Finance and the Center for Economic Policy
Studies at Princeton University Friday afternoon:

Economic research and analysis have proved useful in understanding
many other aspects of the crisis as well. For example, one of the most
important developments in economics over recent decades has been the
flowering of information economics, which studies how incomplete
information or differences in information among economic agents affect
market outcomes. The problem in this case was not a lack of professional
understanding of how runs come about or how central banks and other
authorities should respond to them. Rather, the problem was the failure
of both private- and public-sector actors to recognize the potential for
runs in an institutional context quite different than the circumstances
that had given rise to such events in the past. These failures in turn
were partly the result of a regulatory structure that had not adapted
adequately to the rise of shadow banking and that placed insufficient
emphasis on the detection of systemic risks, as opposed to risks to
individual institutions and markets.

(5 A substantial modern literature has updated and formalized many
of the insights of Bagehot and Thornton. A classic example is Douglas W.
Diamond and Philip H. Dybvig (1983), “Bank Runs, Deposit Insurance, and
Liquidity” Journal of Political Economy, vol. 91 (3), pp. 401-19.)

An important branch of information economics, principal-agent
theory, considers the implications of differences in information between
the principals in a relationship (say, the shareholders of a firm) and
the agents who work for the principals (say, the firm’s managers).
Because the agent typically has more information than the principal —
managers tend to know more about the firms opportunities and problems
than do the shareholders, for example — and because the financial
interests of the principal and the agent are not perfectly aligned, much
depends on the contract (whether explicit or implicit) between the
principal and the agent, and, in particular, on the incentives that the
contract provides the agent.

(6 George Akerlof, A. Michael Spence, and Joseph Stiglitz shared
the 2001 Nobel Prize in Economics for their leadership in the
development of information economics.)

Poorly structured incentives were pervasive in the crisis. For
example, compensation practices at financial institutions, which often
tied bonuses to short-term results and made insufficient adjustments for
risk, contributed to an environment in which both top managers and
lower-level employees, such as traders and loan officers, took excessive
risks. Serious problems with the structure of incentives also emerged in
the application of the so-called originate-to-distribute model to
subprime mortgages. To satisfy the strong demand for securitized
products, both mortgage lenders and those who packaged the loans for
sale to investors were compensated primarily on the quantity of
product they moved through the system. As a result, they paid less
attention to credit quality and many loans were made without sufficient
documentation or care in underwriting. Conflicts of interest at credit
agencies, which were supposed to serve investors but had incentives to
help issuers of securities obtain high credit ratings, are another
example.

Consistent with key aspects of research in information economics,
the public policy responses to these problems have focused on improving
market participants incentives. For example, to address problems with
compensation practices, the Federal Reserve, in conjunction with other
supervisory agencies, has subjected compensation practices of banking
institutions to supervisory review. The interagency supervisory guidance
supports compensation practices that induce employees to take a
longer-term perspective, such as paying part of employees compensation
in stock that vests based on sustained strong performance. To ameliorate
the problems with the originate-to-distribute model, recent legislation
requires regulatory agencies, including the Federal Reserve, to develop
new standards applicable to securitization activities that would better
align the incentives faced by market participants involved in the
various stages of the securitization process.7 And the Securities and
Exchange Commission has been charged with developing new rules to reduce
conflicts of interest at credit rating agencies.

Information economics and principal-agent theory are also essential
to understanding the problems created by so-called too-big-to-fail
financial institutions. Prior to the crisis, market participants
believed that large, complex, and interconnected financial firms would
not be allowed to fail during a financial crisis. And, as you know,
authorities both in the United States and abroad did in fact intervene
on a number of occasions to prevent the failure of such firms–not out
of any special consideration for the owners, managers, or creditors of
these firms, but because of legitimate concerns about potential damage
to the financial system and the broader economy. However, although the
instability caused by the failure or near-failure of some large firms
did indeed prove very costly, in some sense the real damage was done
before the crisis. If creditors in good times believe that certain firms
will not be allowed to fail, they will demand relatively little
compensation for risk, thus weakening market discipline; in addition,
creditors will not have much incentive to monitor the firms
risk-taking. As a result, as predicted by principal-agent theory, firms
thought to be too big to fail tended to take on more risk, as they faced
little pressure from investors and expected to receive assistance if
their bets went bad. This problem is an example of what economists refer
to as moral hazard. The resulting buildup of risk in too-big-to-fail
firms increased the likelihood that a financial crisis would occur and
worsened the crisis when it did occur.

(7 The requirements related to credit risk were contained in
section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection
Act, Pub. L. No. 111-203 (July 2010); with regard to compensation
practices, see Board of Governors of the Federal Reserve System (2009),
“Federal Reserve Issues Proposed Guidance on Incentive Compensation,”
press release, October 22,
www.federalreserve.gov/newsevents/press/bcreg/20091022a.htm; also see
Board of Governors of the Federal Reserve System (2010), Federal
Reserve, OCC, OTS, FDIC Issue Final Guidance on Incentive Compensation,
joint press release, June 21,
www.federalreserve.gov/newsevents/press/bcreg/20100621a.htm.
Why might government intervention be needed to improve
private-sector incentives, when incentives presumably exist for the
private-sector principals and agents to work out the best incentive
structure for themselves? The possibility of problems arising regarding
collective action when a firm has many shareholders is one rationale.
The standard reason for intervening in banks’ risk-taking practices is
the existence of deposit insurance, which itself distorts private
risk-taking incentives by eliminating any incentive of depositors to
monitor the activities of their bank; for an early discussion, see John
Kareken and Neil Wallace (1978), “Deposit Insurance and Bank Regulation:
A Partial-Equilibrium Exposition,” Journal of Business, vol. 51 (July),
pp. 413-38. Indeed, the Federal Reserve invoked a “safety and soundness”
rationale for its guidance on incentive compensation practices. More
generally, as the crisis revealed, bad incentives can lead to problems
that affect not just the individuals involved but the broader financial
system as well; such spillovers suggest that regulation can help improve
outcomes.)

(3 of 5)

** Market News International Washington Bureau: 202-371-2121 **

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