Wednesday, February 25, 2009

Healthy vs. Unhealthy Risk

Could part of the reason for the banking meltdown be the corporate structure of the banks involved? James K. Glassman and William T. Nolan think so. They lay out their case in this WSJ op-ed piece.

They believe that the move from a partnership structure in banks to a corporate structure over the past quarter century led to unhealthy risk taking. While risk taking is essential in any vibrant economy, too much of the wrong kind of risk eventually leads to serious problems — problems that “expose the rest of society to your failures.”

In the case of banking, current and past examples show that partnerships behave in a fiscally conservative manner. Glassman and Nolan offer Brown Brothers Harriman & Co, the nation’s largest and oldest private banking partnership as an emblem of responsibility and stability.

On the other hand, banking corporations tend to take unhealthy risks. Essentially, the managers figure that if something goes wrong, it’s the shareholder’s problem. They have already taken steps to insulate their personal holdings from corporate setbacks.

The basic idea here is that risk tends to perform its proper market function when it is tied to fairly direct accountability. Conversely, when accountability is diminished — when the people in charge of making business decisions do not bear the direct consequences for those decisions — the incentive for responsible behavior is reduced.

“[S]tructure determines behavior …,” write Glassman and Nolan. They suggest that no amount of government oversight will do for banking what a proper business structure will accomplish. They argue strongly for a return to partnership as the preferred structure for banks.

How do you get there from here? Not by governmental requirement, they say. “Rather, investors -- and governments -- should recognize the extra safety inherent in doing business with partnerships.”

The current economic crisis, where businesses and investors are scrambling to find a safe haven, provides a good opportunity for this kind of recognition. The big firms being bailed out do not offer a secure structure for doing business. So, hopefully, people will be wise enough to move to the staid and steady partnerships that offer the desired stability.

I wonder, though, what will happen once the current slump passes. When high-flying unhealthy risk takers offer a better return, will business dollars move back to the banking corporations? If so, it will prove that we have learned little from our present problems.


Anonymous said...

That is an interesting idea. Who would have thought that the legal structure of a banking entity would alter the way that bank personnel do their jobs?

That One Guy said...

Bankers have LONG approached their business using only a short term view. When Boards tie executive compensation to 1/4ly stock performance, excessive risk due to greed creeps in, to the detriment of the long term health and stability of the company. I've long held this view, and it's why I advocate letting banks fail at this point. They deserve to fail, and the greedy shareholders deserve to be wiped out. This brings other institutional shareholders to the point of pain too.... but really, they should fail.

Rather than talk of the government setting up a "bad' bank to sweep up the toxic waste, they should set up a "good" bank, using a taxpayer/government partnership, and get credit flowing again that way.

The news yesterday of AIG having "borrower's remorse on their earlier bailout money, makes it clear the bankers still don't "get it." They are our newest subprime, irresponsible borrowers of money. Let them swing I say.

Scott Hinrichs said...

Perhaps it goes back to the old principle that rarely does anyone manage resources as well as the people that own them.