The Financial Crisis of 2007/2008: Misaligned Incentives, Bank Mismanagement, and Troubling Policy Implications

Abstract

After briefly reviewing the major changes in the financial structure as well as the focal events that characterized the 2007-2008 global financial crisis, this paper considers the evidence for the crucial role played by misaligned incentives. Presumably because compensation was predicated on short-term performance to the neglect of long-term outcomes, participants in the mortgage funding and investment banking industries as well as among credit-rating agencies focused only on their annual activities and disregarded the future impact of their actions on their own firms. Evidence that such indeed is the case is amply spelled out in the text at least for those not serving in senior executive capacities. However, this paper argues that while senior management and especially CEOs were ultimately responsible for such pay policies and handsomely benefited from them, they themselves were not driven by the short-term/long-term pay conflict. The collapse and near-collapse of many financial institutions cannot be attributed to incentive issues at the leadership level, especially as the compensation structures were pervasive throughout the industry while collapse was not. Moreover, CEOs in the investment banking industry were all intelligent, hard-working, inspirational, and successful – at least until 2008. Hence, in explaining why some CEOs succeeded and others failed – and examining the CEOs of Lehman and Goldman Sachs in limited detail – an alternative explanation emerges. The paper rejects the suggestion that risk management staff, especially Chief Risk Officers, were able to restrain some CEOs from overly-risky behavior. Nor did boards of directors make a difference. Instead, for a few CEOs and their firms, the wheel of fortune stopped at “Collapse,” while for most others, the pointer landed on “Safe for Now.” Luck rather than skill determined outcomes. Hence, the paper suggests that constraints on compensation policies both in the US and the EU as well as the broad reforms mandated by the Dodd-Frank Act of 2010 will be of limited value.

Keywords: financial crisis, incentives, bank mismanagement, financial regulation policy

JEL Classification: G21, G28, G34