Re: Bankers have been sold short by market distortions

I feel sorry for Mr. Rajan for writing this article. I thought he is an intellectual. But as often with intellectuals, they get carried away by their knowledge to such an extent that they cannot differentiate between woods and the trees any more.

Coming back to this article, apart from the pretty naive generalisations and assumptions he makes, the awful thing is 'to justify' bankers action to the level of empathy vis-a-vis the regulatory & policy forces unleashed.

An example of a naive generalisations or assumption:

'But short-sellers perform a valuable social function by depriving poorly managed companies of resources they will waste'

I'm sure Mr. Rajan is aware that Short-Sellers don't even own the shares of the company they are shorting. How could they? Then, if they don't hold the shares ie., they are not investors. If they are not investors how are they depriving poorly managed companies of resources they will waste?

I'm sure an investor is smart enough to sell the shares if he feels the management is not up to the task. He or We don't need a short-seller to guide us!!!

Agreed about the regulatory and policy inconsistencies. But that can be discussed as a separate article instead of juxtaposing it with bankers behaviour.

Regards,

Pradeep Kabra

Bankers have been sold short by market distortions
By Raghuram Rajan
Published: June 2 2010 22:37 in Financial Times

Bankers must be heaving a sigh of relief as the shenanigans of the offshore drilling industry have pushed them to the edge of the radar screen of those targeting corporate greed. But it is unlikely their respite will be for long. Inquiries under way are bound to unearth more instances of ethically, and even legally, challenged bankers. When overlaid on images of bankers hankering after their outlandish bonuses soon after being bailed out with public money, the public picture of an industry motivated only by money and without any sense of the larger consequences of its actions will be reinforced. How do we instill more social values in the industry? Or is banker greed mostly good?

Most people do not work for money alone; a primary motivation for many is the knowledge that their work makes the world a better place. Bankers are no different, but their work differs from most other professions in two important ways. First, a broker who sells bonds issued by an electric power project is merely a cog in a gigantic machine, who never sees the plant she helped build. Second, the most direct measure of her contribution is the money she makes for her firm. This is where both the merits of the arm’s-length financial system and its costs arise.

Take for instance a trader who sells short the stock of a company he feels is being mismanaged. He does not see the workers who lose their jobs or the hardship that unemployment causes their families. But short sellers perform a valuable social function by depriving poorly managed companies of resources they will waste. A company whose stock price tanks will not be able to raise financing easily and could be forced to close down.

The trader does not cause the company to go out of business. If he is wrong and the company is well managed, other traders will take the opposite side, buy shares, push up the share price, and make the short seller lose money. It is typically only when the short seller’s opinions come to be widely shared, and company management is truly awful, that the share price tanks. Mismanagement is the source of the company’s troubles; the trader merely holds up a mirror to reflect it.

The best measure of the trader’s value to society is whether he made money from the trade: that indicates he was right to short the firm and that society will benefit from his actions. This is why free-market capitalism works and why bankers usually do good even as they do very well for themselves.

However, when the discipline of markets breaks down, as it sometimes does, the finely incentivised financial system can derail quickly and cause immense damage. The very anonymity of money then makes it a poor mechanism for guiding financiers’ activities toward socially desirable ends. Did the mortgage broker make his fees by offering a variety of sensible options to the professional couple who were looking to upgrade their house, or did he do so by urging an elderly couple to refinance into a mortgage they could not afford? When the broker’s loans are scrutinised by sensible banks that refuse to refinance shaky mortgages, there is a market check on his behaviour that forces him to focus on persuading the professional couple instead of deluding the elderly one. When the market is willing to buy any loan he makes, however, he leans towards easy pickings.

The key then to understanding the recent crisis is to see why markets offered inordinate rewards for poor and risky decisions. Irrational exuberance played a part, but perhaps more important were the political forces distorting the markets. The tsunami of money directed by a US Congress, worried about growing income inequality, towards expanding low income housing, joined with the flood of foreign capital inflows to remove any discipline on home loans. And the willingness of the Fed to stay on hold until jobs came back, and indeed to infuse plentiful liquidity if ever the system got into trouble, eliminated any perceived cost to having an illiquid balance sheet. Chastise the banker who hankers after his bonus, but also pity him for he is looking for his primary measure of self-worth to be restored. Rather than attempting to instill social purpose in him, however, it is probably more useful for society to target the forces that distorted the market.

The writer is professor of finance at the Booth School and author of Fault Lines: How Hidden Fractures still Threaten the World Economy