EconoMonitor

Nouriel Roubini's Global EconoMonitor

Gordon Gekko Reborn

In the 1987 film Wall Street, the character Gordon Gekko famously declared, “Greed is good.” His creed became the ethos of a decade of corporate and financial-sector excesses that ended in the late 1980’s collapse of the junk-bond market and the Savings & Loan crisis. Gekko himself was packed off to prison.

A generation later, the sequel to Wall Street – to be released next month – sees Gekko released from jail and returned to the financial world. His reappearance comes just as the credit bubble fueled by the sub-prime mortgage boom is about to burst, triggering the worst financial and economic crisis since the Great Depression.

The “Greed is good” mentality is a regular feature of financial crises. But were the traders and bankers of the sub-prime saga more greedy, arrogant, and immoral than the Gekkos of the 1980’s? Not really, because greed and amorality in financial markets have been common throughout the ages.

Teaching morality and values in business schools will not tame such behavior, but changing the incentives that reward short-term profits and lead bankers and traders to take excessive risks will. The bankers and traders of the latest crisis responded rationally to compensation and bonus schemes that allowed them to assume a lot of leverage and ensured large bonuses, but that were almost guaranteed to bankrupt a large number of financial institutions in the end.

To avoid such excesses, it is not enough to rely on better regulation and supervision, for three reasons:

  • Smart and greedy bankers and traders will always find ways to circumvent new rules;
  • CEOs and boards of directors of financial firms – let alone regulators and supervisors – cannot effectively monitor the risks and behaviors of thousands of separate profit and loss centers in a firm, as each trader and banker is a separate P&L with its own capital at risk;
  • CEOs and boards are themselves subject to major conflicts of interest, because they don’t represent the true interest of their firms’ ultimate shareholders.

As a result, any reform of regulation and supervision will fail to control bubbles and excesses unless several other fundamental aspects of the financial system are changed.

First, compensation schemes must be radically altered through regulation, as banks will not do it themselves for fear of losing talented people to competitors. In particular, bonuses based on medium-term results of risky trades and investments must supplant bonuses based on short-term outcomes.

Second, repeal of the Glass-Steagall Act, which separated commercial and investment banking, was a mistake. The old model of private partnerships – in which partners had an incentive to monitor each other to avoid reckless investments – gave way to one of public companies aggressively competing with each other and with commercial banks to achieve ever-rising profitability, which was achievable only with reckless levels of leverage.

Similarly, the move from a lending model of “originate and hold” to one of “originate and distribute” based on securitization led to a massive transfer of risk. No player but the last in the securitization chain was exposed to the ultimate credit risk; the rest simply raked in high fees and commissions.

Third, financial markets and financial firms have become a nexus of conflicts of interest that must be unwound. These conflicts are inbuilt, because firms that engage in commercial banking, investment banking, proprietary trading, market making and dealing, insurance, asset management, private equity, hedge-fund activities, and other services are on every side of every deal (the recent case of Goldman Sachs was just the tip of the iceberg).

There are also massive agency problems in the financial system, because principals (such as shareholders) cannot properly monitor the actions of agents (CEOs, managers, traders, bankers) that pursue their own interest. Moreover, the problem is not just that long-term shareholders are shafted by greedy short-term agents; even the shareholders have agency problems. If financial institutions do not have enough capital, and shareholders don’t have enough of their own skin in the game, they will push CEOs and bankers to take on too much leverage and risks, because their own net worth is not at stake.

At the same time, there is a double agency problem, as the ultimate shareholders – individual shareholders – don’t directly control boards and CEOs. These shareholders are represented by institutional investors (pension funds, etc.) whose interests, agendas, and cozy relationships often align them more closely with firms’ CEOs and managers. Thus, repeated financial crises are also the result of a failed system of corporate governance.

Fourth, greed cannot be controlled by any appeal to morality and values. Greed has to be controlled by fear of loss, which derives from knowledge that the reckless institutions and agents will not be bailed out. The systematic bailouts of the latest crisis – however necessary to avoid a global meltdown – worsened this moral-hazard problem. Not only were “too big to fail” financial institutions bailed out, but the distortion has become worse as these institutions have become – via financial-sector consolidation – even bigger. If an institution is too big to fail, it is too big and should be broken up.

Unless we make these radical reforms, new Gordon Gekkos – and Charles Ponzis – will emerge. For each chastised and born-again Gekko – as the Gekko in the new Wall Street is – hundreds of meaner and greedier ones will be born.

Nouriel Roubini is Professor of Economics at the Stern School of Business, NYU, Chairman of Roubini Global Economics (www.roubini.com), and co-author of the book Crisis Economics. He has a cameo role in Oliver Stone’s new film Wall Street: Money Never Sleeps.

Originally published at Project Syndicate


All rights reserved, Roubini GlobalEconomics, LLC

8 Responses to “Gordon Gekko Reborn”

GuestAugust 15th, 2010 at 11:32 am

NR, I thought you to be more insightful and fair than this report suggests. The problems above are more to blame on big government than greedy investors, CEOs, corporations or boards of directors. The 1986 Tax Act retroactively changed the rules on real estate, thus bringing down the whole Savings and Loan industry and many insurance companies. The Community Reinvestment Act forced banks to lend to people unable and unwilling to repay their loans. Both times the government interfered with disasterous consequesces. To suggest all our problems have been caused by hard working capitalists is irresponsible.

11b40August 15th, 2010 at 2:02 pm

With all due respect, Guest, that is simply Hogwash.Not that I don’t blame government for many, many poorly written laws and horrible oversight, but the Community Reinvestment act did not FORCE any bank to loan to anyone unqualified. In addition, there were a number of problems and issues leading up to the Savings & Loan debacle of the 80’s. At least people (very few) went to jail back then.Do you have any arguments to make against the points made in the article at hand? I think each of them is valid and overdue to be addressed.Independent Contrator

economicminorAugust 17th, 2010 at 9:22 am

Very good Professor,I agree with your assessment and general solutions.The problem is so much bigger than just understanding and solutions though. There is a huge problem with the way the government works.Campaign finance and lobbying run the agenda of all who successfully run for office.All we need now is a Congress and a President that are free from the overriding influence of never ending campaigns with the need to raise money from the same people whom they are suppose to be regulating. The financing of campaigns are the same enties causing the economic instability.The Supreme Court’s ruling giving corporations the right to campaign and lobby with neither impunity nor limits was the climax of the corporate power agenda. Now we have all three branches of government who are beholding to or have the same agenda. Our Constitution was suppose to keep the minority from subjecting the majority yet the Supreme Court gave the minority the right to own and control the majority. Corporations aren’t even natural citizens.I have no idea how sanity or stability can now be achieved? Power has no agenda except more power. We the People no longer have any legislative control and all the suggestions you have made have no chance of being enacted.How can any real reform be enacted when secret corporate money can out shout all attempts at any rational change that might reign in the speculation and behavior that is good for them and bad for the majority?

BrendaAugust 21st, 2010 at 3:47 am

I personally experienced greed, as described by NR in the above article. He is dead on as usual. Of course the government left it to the banks to regulate themselves and therein lies the problem. It’s the paring down of government and the wasteful spending of the wars on Drugs, Iraq,and Afganistan that have contributed to the government looking the other way.Capitalism must be held in check by government, at least to a minimum degree.I don’t feel that minimum standard has been met.It has eroded continually.

sierraAugust 21st, 2010 at 10:40 am

you cannot have a “corrupt free” financial system without a “corrupt free Congress/Senate”.All of NR points are extremely valid; you have to understand the enormous changes in banking/financials after WW2……driving banks to look for more ways to make their money especially since corporations then realized they could raise thier own monies, sell their own bonds…..it’s a long story but one well worth studying….my research for a book, yet unfinished about this mess I think does a good job..

GuestAugust 27th, 2010 at 1:23 am

greed vs moralityi think morality is dead, in general, in the 21th century.greed, is the normal. law, legislation, enforcement, control etc, are not working effectively, anymore.so, those with some sanity, are having tough time. they must work hard to keep going, sacrificing, practicing their transcendental faiths, or else flocking with the common majority….but, truth needs to be passed on to future generations. we know for sure, the world needs morality for the well being of our children’s children. so, a lot of moral volunteers are required, anyone?don’t talk void if you do not fit in, don’t try if you are not tough enough…