Misaligned Incentives in Markets: Envisioning Finance That Benefits All of Society

Abstract

The modern financial system is plagued by misaligned incentives that allow some firms to extract distributive profits, and direct wealth transfers in their favor, without producing anything of value, or improving society with enhanced employment or socially useful innovation. Many modern financial products and activities serve no underlying economic or productive purpose. The system is creating market intermediaries of astounding size, power, profitability, and economic and regulatory policy influence. Some financial firms expressly profit from heightened interconnection and complexity, while others benefit directly from increased volatility. Yet we all bear the costs of this evolved financial system when it unravels due to its interconnectedness with the real economy, and our increased reliance on markets. This article advocates for a financial system that is de-financialized, de-complexified, more transparent, and better orientated to productive ends in a way that benefits all of society, not just the firms who reap asymmetrical payoffs in a complex system, intermediate capital, create financial products, or run the plumbing in a system that ultimately serves them best.

This article gives support to Hyman Minsky’s “money manager capitalism” hypothesis by showing how the financial system has evolved since the 2008 crisis because of misaligned incentives. In support of this contention the article profiles numerous post-crisis trends and events in financial markets where misaligned incentives emerge, including moral hazard in debt origination, how some financial firms benefit from volatility; the real winners of the Game Stop “meme stock” saga; problems from price dislocations in credit exchange traded funds (ETFs) during the coronavirus pandemic crash; conflicts in the construction and composition of indices; market disruption from volatility-linked exchange traded products (ETPs); misaligned incentives in special purpose acquisition companies (SPACs) and evolved private equity (PE) business models; fragilities in pension administration; environmental, social, governance (ESG) opacity and greenwashing in investment funds; and governance conflicts from economic and proxy voting power of mega-asset managers.

Keywords: Financial system, financial market, minsky, financialization, incentives, financial crisis, moral hazard, debt origination, meme stock, ETF, exchange traded fund, ETP, SPAC, private equity, ESG, indexing, investment funds, greenwashing, corporate governance

JEL Classification: G00, G01, G10, G18, G20, G23, G24, G28, K20, K22