Asymmetric information and corporate governance in bank bailouts

Submitted by Edward Harrison of Credit Writedowns.

So, things are looking a lot brighter we are told by most economists and policy makers. The crisis is over and the banking system is on the mend. Now is the time for true reform and for bankers to get back to business as usual.

While the foregoing may make for nice copy in the mainstream media, I would like to make the case for continued vigilance, especially in regards to corporate governance and incentives in the banking sector. Let’s look at this from the point of view of a big bank CEO who we will call Phil.

Now, Phil was caught unawares when the credit crisis hit. His bank, where he had been CEO for a decade, had been growing prodigiously at relatively low risk according to internal risk metrics. The return on capital was top quintile. But, the financial crisis and recession had not been kind to the bank. Big Bank had taken massive credit writedowns and was forced to take on TARP money and issue FDIC insured bonds in order to demonstrate its safety as a bank. As a consequence, the share price was crushed, falling 80% peak to trough. All of Phil’s stock options were underwater.

But, the stress tests showed that Phil’s bank was in relatively good shape – at least compared to Big Bank’s peers. On the back of this information, Big Bank was able to issue a huge slug of new shares at a price 200% above its trough share price and fill any apparent gaps in Big Bank’s capital. In fact, under the guidelines of the stress test, Big Bank could pay back all of the TARP money it received and return to business as usual.

There was one problem, however, and Phil knew it. You see, Phil had become a lot more worried about the health of his bank after being caught flat-footed when the credit crisis hit. The company had done a significant amount of work to get to grips with likely credit exposure. And while the situation was good for Big Bank under the conditions predicted in the government’s stress tests, Phil knew that the conditions were not good at all in more adverse scenarios. What should Phil do?

Before, we get into what Phil actually does, I should point out that this is a classic case of asymmetric information in which Phil, as a bank insider, has a lot more knowledge of Big Bank’s financial condition than the government, shareholders, or the investing public at large. Well, I would like to believe that Phil would do the prudent thing and remain ‘over-capitalized’ until he was sure that he could lend prudently without jeopardizing his firm’s capital base. But, there is clearly no incentive for that. After all, hadn’t Phil been beaten over the head before Congress for ‘not’ lending money. Why did Phil have so many billions of dollars in excess reserves at the Fed? Why was he preventing the economy from regaining its footing? Was Phil hiding something? Perhaps Phil and his executive team need to be replaced? On second thought, Phil decides the over-capitalization route is suicidal.

As it turns out, Phil’s internal credit gurus told him there is a 60% chance that the company can lend and make shed loads of money as the economy recovers. There is a lesser but not insignificant 30% chance that the company is under-capitalized if the economy remains fragile and a 10% chance that the company is severely-undercapitalized in a real worst-case scenario. Big Banks lawyers and accountants have told Phil that he can legitimately claim to the public that Big Bank is well-capitalized and proceed lending.

Phil is optimistic that things will turn out well. The fact that his underwater options depend on it is no small incentive to feel that way. But, he has nagging doubts about the downside scenarios of which the public and the government are largely unaware. So Phil decides to ‘reach for yield’ by taking a slightly aggressive strategy which will ensure that the company can make a lot of money now while interest rate spreads are high. That way, if things turn down, he will have a huge cushion with which to work.

Of course, he could get burned again and be forced into an under-capitalized position. That would be embarrassing. But, a bailout is likely if worse comes to worst and no CEOs were replaced the last go around. Sure they made noises about replacing Vikram Pandit, but he is still in office. And, anyway, Phil is a member of the club – the exclusive cadre of well-experienced bank executives who run America’s banking system. Surely he would land on his feet after a time.

Notice I have not suggested that we have any evil banksters here; I am simply demonstrating that misaligned incentives lead to poor outcomes. Phil, who has zero incentive to restrict lending, has a lot of incentives to increase lending: threats from the government and a huge options pay package being the most obvious. And certainly, if Phil fails, it’s not as if his options will exact a penalty; they expire worthless, making Phil indifferent to all scenarios in which they are not in-the-money.

All of this points out why bailouts skew executive behavior in a way that makes the system more volatile. Moreover, the fact that large options packages incentivize risk-taking by making executives relatively indifferent to all scenarios below the option strike price, show that executive compensation exacerbates the volatility. Certainly, this is one reason we need to address compensation and incentives more than is done in the Obama white paper.

But, more than that, the asymmetry in knowledge makes the way this crisis has been handled — bailouts, stress tests, hidden subsidies – quite disturbing. And the Obama White Paper for regulatory reform does not go far enough to ensure that this same downside scenario will not repeat itself.