Wall Street Lessons
By Mario Daniel Anthony Turse Contributor November 8, 2010

The ability to predict human behavior is tantamount to the ability to predict the future. Whether predicting the behavior of opposing legal counsel in a trial, of rival politicians in an election, or of investors in the market, knowledge of human behavior is paramount. The key to unlocking human behavior lies in understanding decision making, and decision making, is motivated by incentives. To provide a concrete and dramatic example, the two scenarios below highlight the role of incentives in financial markets. Whether in a simple market in the developing world, or in a complex and fast-paced financial center, similar incentives create similar behavior, and ultimately, create identical results.

Scenario One: A micro-credit loan officer in Uganda wishes to maximize her performance bonus. Since bonuses are based on loan size and volume, she acts rationally and focuses on providing larger loans and providing more loans. This system encourages loan size and quantity, over how the loans are used and the ability to repay. Consequently, the loan officer develops a lack of individual knowledge about the borrower and the loan usage. The result: higher rates of delinquency and loan default.

Scenario Two: Take Scenario One, and replace “micro-credit” with “housing,” and “Uganda” with “the United States.” The only difference between these scenarios is their potential impact. As the past two years have shown, the connectivity between the US housing market and other financial markets means that one small misinterpretation of incentives such as this can spread financial “contagion” worldwide, and threaten the global banking system.

Solutions are sought in both scenarios, some with more success than others. In Uganda, the micro-credit agency looks to correct its mistakes and realizes its incentive structure is skewed. It determines that socio-economic development is its primary goal, and lending is simply a means to achieve this goal. Bonus structures are therefore reworked so that bonuses are distributed only if both financial and socio-economic goals are met. Consequently, loan officers are now encouraged to have knowledge about loan use (i.e. knowledge of what happens after the loan is dispersed), and they are therefore incentivized to be continuously well-informed about individual borrowers and local conditions (both of which can affect loan repayment). In short, the new system encourages loan officer to remain in close contact with the community where the loan was disbursed.

In the United States, no clear solution has been enacted yet, but current discussion focuses on regulation – with the main sticking points being the exact form and strictness of the regulation. What these proposed solutions have in common, is their desire to directly legislate loan oversight (e.g. requiring explicit disclosure of when and how interest rate changes may affect repayment) to increase transparency in the loan process.

International financial innovation has created a system where an individual loan can be segmented and sold in the global marketplace to whoever desires that particular segment. For instance, imagine a loan to construct a house in Des Moines, Iowa. Once the initial loan is made, it is segmented in terms of risk – for simplicity, a low, medium, and high-risk segment – and these segments are then sold in London, Tokyo, and Hong Kong to purchasers who desire the particular risk level. Theoretically, this system will create a more “efficient” allocation of risk because each purchaser receives only the specific segment (and the specific risk level) desired.

However, because the purchasers of these loan-segments are unlikely to have direct knowledge of the original borrower or the local conditions where the loan funds will be used, an unintended (and therefore un-priced) relationship forms. As purchasers of these loan-segments become increasingly distant from the local conditions where the loan originated, transparency regulations are required so that parties can make more informed decisions. Unfortunately, while regulating transparency can provide relevant information, transparency alone is not sufficient to promote responsible use of the information.

The current financial crisis resulted from a culmination of problems that developed over time, from misguided public policies, to distorted income distributions, to ill-conceived incentive structures, to inaccurate calculations of risk; it was not caused by a singular event. Just as the financial crisis did not stem from a single event, it is foolish to think that a single piece of legislation can reverse the process and bring a quick return to prosperity. As with most issues of this complexity, changes are required at various levels, and positive results will be noticed very slowly.

It is important that legislation provides markets with the correct incentives – current U.S. proposals for banking regulation lack incentives for long-term responsibility. The ability to deconstruct and resell a loan for profit, weakens incentives for “due diligence” and long-term considerations about loan repayment. Regulating increased disclosure and transparency is simply insufficient to counterbalance profit incentives.

Any proposed U.S. legislation to the banking sector should learn from micro-credit lenders in developing nations and hold those making the initial loans directly responsible for ongoing (i.e. long-term) loan performance. Such legislation would promote direct responsibility, incentivize continuous and long-term loan management, and would involve less bureaucratic oversight. In short, it would provide a cheaper, more stable, and longer-lasting means of avoiding similar crises in the future.

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