This paper is a comparison between the current financial crisis and the asian crisis from 1997/98. The author argues that one of the main reasons that caused both crisis were flawed incentives. The paper was a basis for a class discussion, hence it is strongly focused on this argument.
Table of Contents
1. Introduction
2. The Current Financial Crisis
3. The Asian Currency and Financial Crisis
4. Comparison and Personal Statement
5. Conclusion
Objectives and Topics
This paper examines how flawed incentive structures have acted as a primary driver behind major financial market failures, specifically analyzing the recent global financial crisis and the 1997-1998 Asian currency crisis.
- The impact of short-term compensation models on banking risk-taking.
- Macroeconomic policy incentives and their role in regional financial bubbles.
- Agency conflicts and the role of controlling shareholders in crisis development.
- The necessity for long-term risk-oriented incentive contracts.
- Evaluation of regulatory frameworks and corporate governance in preventing systemic failure.
Excerpt from the Book
The Roots of the Current Financial Crisis
The roots of the current financial crisis lie in the housing bubble. The banking system has suffered from the burst of the bubble for two main reasons: First, banks have been able to place assets in off-balance-sheet vehicles and hence did not have to hold capital buffers against them. Second, banks could lower their regulatory capital requirements by investing in “AAA”-rated securities, mainly mortgage-backs or related derivatives, what enables them to operate with higher leverage. Even if banks have been aware of the incorporated risk of this business, the existing incentive systems encouraged the traders to invest in these assets. Short-term cash bonuses based on sales volume rather than on long-term profitability, blinded bankers towards mismatches of financing long-term assets with short-term debt and liquidity risk. With the burst of the bubble, the banks had to deal with the real risk in and off their books, while the short-term bonuses are already paid out to the employees.
This short summary of the financial crisis shows that employees have been encouraged to “bet” on mortgage-back securities in order to maximize their own salary on a short-term basis, due to the fact that they will not be responsible for the long-term profitability of the bank or its risk position. As a result one could argue, that we still need to learn more about risk and how to incentivize managers and employees by lowering risk by simultaneously maximizing profits.
Chapter Summary
1. Introduction: Defines the concept of incentives and introduces the core argument that flawed incentive structures are a common cause of financial instability.
2. The Current Financial Crisis: Analyzes how short-term bonus schemes and regulatory arbitrage through off-balance-sheet vehicles contributed to the housing bubble collapse.
3. The Asian Currency and Financial Crisis: Explores how government-led incentives for foreign currency lending and agency conflicts between controlling and minority shareholders fueled the 1997-1998 crisis.
4. Comparison and Personal Statement: Contrasts the macroeconomic nature of the Asian crisis with the microeconomic nature of the recent global crisis and provides a perspective on future incentive design.
5. Conclusion: Summarizes the necessity of regular evaluation of incentive contracts and the integration of risk models to prevent future systemic failures.
Keywords
Financial Crisis, Flawed Incentives, Banking System, Mortgage-backed Securities, Leverage, Risk Management, Asian Financial Crisis, Agency Theory, Corporate Governance, Capital Buffers, Macroeconomics, Microeconomics, Compensation, Regulatory Capital, Systemic Failure
Frequently Asked Questions
What is the fundamental premise of this paper?
The paper argues that flawed incentive structures, which prioritize short-term gains over long-term stability, are a root cause of significant financial crises.
Which financial events are analyzed as case studies?
The author examines the recent global financial crisis and the 1997-1998 Asian currency and financial crisis.
What is the primary objective of the research?
The goal is to understand how specific incentive systems encourage behaviors that lead to crisis and to propose better, risk-conscious incentive designs for the future.
Which scientific framework is mentioned regarding the creation of contracts?
The paper references agency theory to explain why it is inherently difficult to design perfect incentive contracts.
What does the main body cover in terms of analysis?
It covers the mechanisms of the housing bubble, the role of off-balance-sheet vehicles, government tax incentives in Asian markets, and the behavioral impact of bonus schemes on risk-taking.
Which keywords best characterize this work?
Key topics include financial crises, incentive structures, agency theory, risk management, and regulatory oversight.
How does the author distinguish between the two crises regarding the level of influence?
The author notes that the Asian crisis was primarily influenced at the macroeconomic level (governments vs. banks), whereas the recent global crisis was driven by microeconomic factors (employer banks vs. employees).
What role did the Bangkok International Banking Facility (BIBF) play in the Asian crisis?
The BIBF provided special tax breaks and relaxed reserve requirements for foreign currency lending, which artificially encouraged high capital inflows and made the system vulnerable to panic.
Why are current incentive contracts considered difficult to optimize?
Due to the complexity of banking risks, it is nearly impossible to create contracts that accurately reflect all existing and expected risks, leading to a recurring possibility of system failures.
- Arbeit zitieren
- Mario Pesch (Autor:in), 2010, Financial Crisis: Flawed Incentives Cause Banking Crises, München, GRIN Verlag, https://www.hausarbeiten.de/document/164361
