Monday, November 3, 2008

Economist's FAQ on the Financial Crisis of 2008

Ivo Welch, Professor of Economics and Finance at Brown University, has posted a "frequently asked questions" (FAQ) document, primarily designed for non-economists, about the current financial crisis.  Though written from the perspective of an economist, the FAQ provides an excellent plain language discussion of the magnitude of the mortgage losses, some of the problems that caused the current financial mess, and some potential remedies. 

Interestingly, corporate governance is listed as chief among the deepest causes of the financial crisis, followed by the U.S. Tax Code, the bankruptcy laws, and the rating agencies. 
The U.S. corporate governance system is badly broken. There has been a lack of good corporate governance in the U.S. for decades. This is an economy-wide problem. It is just that in finance, everything happens with more gusto. (Arguably, bad corporate governance has also largely destroyed the American car industry.)

It was poor corporate governance that made it in the interest of management and employees in banks to gamble with the shareholders' money, much more than the shareholders would have wanted to gamble themselves.

Shareholders would have wanted some gambling (call it risk-taking), especially if it was smart and had positive expected returns—which it did for many years. Arguably, it was also in the shareholders' interest to gamble with the taxpayers' money. I judge that this was of much lesser importance than the misaligned CEO incentives.

It is the task of the Chairman of the Board (and the Board) to make sure that the CEO does a good job—not just in terms of current earnings, but also in terms of controlling risk, investing in long-term ventures, etc. Unfortunately, it is rare that poor CEOs are fired by their Chairmen, because in most corporations the CEO is also the Chairman. The fact is that shareholders in large, old companies have very little influence. This is not an easy problem to fix, but if we want to improve the economic system in the United States, improving our corporate governance is of paramount concern.

In addition to reforms of the tax and bankruptcy codes, Welch suggests two more novel reforms: the establishment of a corporate governance standards board, as well as the redirection of the focus of the SEC from rules and enforcement to effective economic regulation:
We should establish a “Corporate Governance Standards Board” (similar to FASB) in charge of “Generally Acceptable Corporate Governance Standards” (similar to GAAP). This board should be endorsed by the SEC, with additional safe-harbor provisions for firms following these standards and fewer protections for CEOs not following these standards.

We should appoint a (legal) economist as head of the SEC, rather than a politician or pure lawyer. The SEC focus needs to tilt away from its traditional focus on enforcement and pure rule-based thinking and more towards effective economic regulation.

The full text of Professor Welch's FAQ is available at: