Wall Street actions are a result of incentives

How can the financial crisis be a result of anything other than the incentives created by incomplete regulation and incorrect company structure?

People will always respond to the strongest incentives they see and are able to take on. The strongest incentives are so far-reaching across financial firms and the government:

  • Complete lack of either oversight or transparency of the derivatives market creates the incentive to build supposedly market-neutral bets that are orders of magnitudes larger than what capital reserve requirements dictate
  • Compensation packages that pay bonuses now on trades that can blow up later creates incentives for employees to take risks now; if the house falls down, they will be laid off, but will also be much wealthier.
  • The tacit understanding that the largest banks and hedge funds will be rescued no matter how stupid the actions that got them there to begin with creates the incentive to take on increasingly risky positions. If you aren’t playing with house money, you will be playing with taxpayer money.
  • The SEC’s inability to regulate Wall Street, because Congress told them not to, because they were told that regulation hampers innovation by a Wall Street lobbyist, creates the incentive to continue doing what you are doing, as no one from the government will bother you.

I am sure I am missing probably 3-4 other causes for these incentives, but to me these are the biggest.

The financial regulation bill reaching Congress today is a step in the right directly, but will likely introduce or leave behind holes. This will create additional incentives that financial firms will rush to fill. I don’t know what those holes are, as I haven’t read any part of the bill, but I know they will be picked apart by the blogs I do read (mentioned below).

Any argument that talks about morals (e.g. “Wall Street is too greedy”) is doomed to fail. Spend five minutes with a trader from one of these firms, and economic morals is generally completely lost on them. They wouldn’t be successful traders if this wasn’t the case, as their jobs are to take advantage of these kinds of inefficiency.

This post was inspired by this summary from Russ Roberts on Marginal Revolution, as well as from two years of reading Naked Capitalism and Marginal Revolution

“1. It isn’t “too big to fail” that’s the problem, it’s the rescue of creditors going back to 1984, encouraged imprudent lending and allowed large financial institutions to become highly leveraged.

2. Shareholder losses do not reduce the problem even when shareholders are the executives making the decisions

3. These incentives allowed execs to justify and fund enormous bonuses until they blew up their firms. Whether they planned on that or not doesn’t matter. The incentives remain as long as creditors get bailed out.

4. Changes in regulations encouraged risk-taking by artificially encouraging the attractiveness of AAA-rated securities.

5. Changes in US housing policy helped inflate the housing bubble, particularly the expansion of Fannie and Freddie into low downpayment loans.

6. The increased demand for housing resulting from Fanne and Freddie’s expansion pushed up the price of housing and helped make subprime attractive to banks. But the ultimate driver of destruction was leverage. Either lenders were irrationally exuberant or were lulled into that exuberance by the persistent rescues of the previous three decades.”

(Side note: I use the term Wall Street quite loosely here. In reality, many firms that contributed are not physically on Wall Street, and many that are on Wall Street did not contribute in meaningful ways.)

The Chicago Bureaucracy

I recently spent a miserable 2 hours and 15 minutes at the Chicago Department of Business Affairs & Licensing, and wanted to share my experience in case anyone in the Mayor Daley’s bureaucracy is listening.

My experience
Our company was recently given a fine for not having and posting a City of Chicago Business License. Well, we didn’t know we were supposed to have one. So, fine, I was going to figure this out.

I go to the city’s website and request to schedule an appointment online. The website says “Your appointment will be confirmed via email within one (1) business day from receipt of the original request.” Two business days come and go, and I hear nothing, so I decide to call them.

Two days later, I go for my appointment. In preparation, I had spent 30-40 minutes gathering information for and completing the 2 page application. I arrive, check in, and am told to wait in the waiting area with about 30 chairs, 15 other people, and CNBC blaring at a ridiculous volume. A giant painting of Mayor Daley watches over us paternally, and signs below him indicate in big letters that

  1. All cell phone use is prohibited, and
  2. The office is monitored by the Chicago Police Department, should I decide to do something rash because of, say, extreme frustration at the process I am about to endure.

10 minutes after arriving, the “Business Consultant” with whom I have an appointment (let’s call her Joan) calls me in. I sit in Joan’s cubicle and give her my 2 pages of forms. I then proceed to watch quietly as she very slowly copies the information on my forms into her computer. During the process, she asks me to clarify a few things (e.g. “What are the home addresses of the members? What does this word say?”) This takes 30 minutes. To enter… 2… pages… of… forms…

Joan then tells me to wait in the waiting area for a response, which will be approximately 20 minutes.

40 minutes later, as I’m trying to figure out why its taking so long, Joan finally calls me back in. We sit at her cubicle again, and she explains to me that the city’s zoning division could not approve our city license without asking a single follow-up question: do we do repairs on-site? No, no repairs. “Okay, I will convey that information to them. You will need to wait outside for another 20 minutes for the zoning department to review your answer and approve your license.


So, I head back out into the waiting area, where members of a CNBC panel are yelling at each other about whether mortgage rates will rise or fall. This time I notice that, while waiting for a response, she had called in two other people to help them out. I’m all for parallel processing, but if what could have taken less than 5 minutes to get a response now requires me to wait 30 minutes because Joan decides to see two other people, I tend to get frustrated.

Joan finally appears. She tells me that the license has been approved, and I can either wait for it to be printed, or have it mailed to our business. I figured, since I’m here, I will wait. What’s a few more minutes?

I pay for our license ($250), taking another 5 minutes, and sit back down to wait.

I should have had it mailed. Another 20 minutes pass before I am called back up and given a license.

Why is this frustrating?
I spent over 2 hours at the Chicago Business Affairs & Licensing Department. ~75% of my time there was spent waiting, the other 25% spent watching Joan type in my information. My company had to pay me to wait, and my tax dollars had to pay for Joan to be an overpaid order entry monkey.

Why could I not have just typed this form into a website directly? Sure, some people will not be able to follow simple instructions online, and will require someone from the city to walk them through it. But my guess is that this comprises no more than 30% of business owners who come into the department.

Come on Chicago, get with it! The cost of this license wasn’t $250. It was $250 + my >2 hours + the “Business Consultant”‘s time + overhead maintaining a giant Business Affairs & licensing Department.

The kicker
Two days after this ordeal, I get a call from the Business Affairs & Licensing department. They are calling to respond to the original website submission, to help me schedule an appointment. Remember that one? The one that was supposed to be “confirmed via email within one (1) business day from receipt of the original request.”? Right. It took four business days to give me a call.