IncentivesandthePerformanceofAmericasFinancialSector HouseCommitteeonFinancialServices HearingonCompensationintheFinancialIndustry TestimonybyJosephE.Stiglitz1 January22,2010 ItisbothasourceofpleasureandsadnesstotestifybeforeyoutodayIwelcome thisopportunitytotestifyonthisimportantsubject,butatthesametime,itisa sourceofsadnessthatyoushouldhavetoholdhearingsonthismatter,morethan twoyearsaftertheonsetoftheGreatRecessionof2008. Inthisbrieftestimony,Icanonlytouchonafewkeypoints.ManyofthesepointsI elaborateinmybookFreefall, 2whichwaspublishedjustafewdaysago. Ourfinancialsystemfailedtoperformthekeyrolesthatitissupposedtoperform foroursociety:managingriskandallocatingcapital.Agoodfinancialsystem performsthesefunctionsatlowtransactioncosts.

.Ourfinancialsystemcreatedrisk andmismanagedcapital,allthewhilegeneratinghugetransactioncosts,asthe sectorgarneredsome40%ofallofcorporateprofitsintheyearsbeforethecrisis. Thesectorisalsoresponsibleforrunningthepaymentsmechanism,withoutwhich oureconomycannotfunction.Butsobadlydiditmanageriskandmisallocate capitalthatourpaymentsmechanismwasindangerofcollapse.Sodeceptivewere thesystemsofcreativeaccountingthatthebankshademployedthat,asthecrisis evolved,theydidntevenknowtheirownbalancesheets,andsotheyknewthatthey couldntknowthatofanyotherbank.Nowonderthenthatnobankcouldtrust another,andnoonecouldtrustourbanks.Nowonderthenthatoursystemof creditthelifebloodonwhichtheeconomydependsfroze.Wemaycongratulate ourselvesthatwehavemanagedtopullbackfromthebrink,butweshouldnot forgetthatitwasthefinancialsectorthatbroughtustothebrinkofdisaster. 1TheauthorisUniversityProfessoratColumbiaUniversity,teachinginthe DepartmentofEconomics,theGraduateSchoolofBusiness,andtheSchoolof InternationalandPublicAffairs.HeformerlyservedasChairmanoftheCouncilof EconomicAdvisers(19951997)andasChiefEconomistandSeniorVicePresident oftheWorldBank(19972000).HewasawardedtheNobelMemorialPrizein Economicsin2001andwasaleadauthoroftheIntergovernmentalPanelon ClimateChangeReportof1995;theIPCCsharedtheNobelPeacePrizein2007.The workforwhichhewasawardedtheNobelMemorialPrizeinEconomicsisrelatedto financialmarketsandincentives,thesubjectmatterofthishearing. 2PublishedbyW.W.Norton,2010. 1

Ishouldqualifytheseremarks,andmuchofwhatIshallsaylater,byageneral caveat:partsofourfinancialsystemhavedoneanexcellentjob.Later,whenIwrite disapprovinglyaboutthefinancialsectorsmistakes,itsmisallocationofresources, itsmismanagementofrisk,anditspredatoryactivities,Ishouldemphasizethat therewereotherpartsofthefinancialsectorthatdidwhattheyweresupposedto doandeventriedtoputacheckonthemisbehaviorofothers.Americasventure capitalfirmshelpprovidefinancetosomeofAmericasinnovativefirmsandplayan importantroleintheeconomyslongtermsuccess.Butthesefirmsareasmallpart ofthefinancialindustry.Moneythatwentintohousingthatbuyerscouldnotafford couldhavebeenusedtofinancenewinvestmentthatwouldhaveincreasedthe longrunproductivityofoureconomy.Resourcesarescarce,andourfinancial sectormisallocatedthesescarceresourcesonamassivescale.Thecrisishas reportedlyforcedventurecapitalfirmstocutbackinvestment;thesedynamicparts ofAmericaseconomywillbeforcedtopayahighpriceforothersmistakes. Whilethefailuresofthefinancialsystemthatledtheeconomytothebrinkofruin are,bynow,obvious,thefailingsofourfinancialsystemaremorepervasive.Small andmediumsizedenterprisesfounditdifficulttogetcredit,evenasthefinancial systemwaspushingcreditonpoorpeoplebeyondtheirabilitytorepay.Modern technologyallowsforthecreationofanefficient,lowcostelectronicpayment mechanism;butbusinessespay1to2percentormoreinfeesforatransactionthat shouldcostpenniesorless. Ourfinancialmarketsnotonlymismanagedriskandcreatedproductsthat increasedtheriskfacedbyothersbuttheyalsofailedtocreatefinancialproducts thatwouldhelpordinaryAmericansfacetheimportantrisksthattheyconfronted, suchastherisksofhomeownershiportherisksofinflation.Indeed,Iamintotal agreementwithPaulVolckeritishardtofindevidenceofanyrealgrowth associatedwiththesocalledinnovationsofourfinancialsystem,thoughitiseasyto seethelinkbetweenthoseinnovationsandthedisasterthatconfrontedour economy. Underlyingallofthesefailuresisasimplepoint,whichseemstohavebeen forgotten:financialmarketsareameanstoanend,notanendinthemselves.Ifthey allocatecapitalandmanageriskwell,thentheeconomyprospers,anditis appropriatethattheyshouldgarnerforthemselvessomefractionoftheresulting increasesinproductivity.Butitisclearthatpaywasnotconnectedwithsocial returnsorevenlongrunprofitabilityofthesector.Formanyfinancial institutions,lossesafterthecrisisweregreaterthanthecumulativeprofitsinthe fouryearsprecedingthecrisis;fromalongertermperspective,profitswere negative.Yettheexecutiveswalkedoffwithamplerewards,sometimesinthe millions.MostgallingformanyAmericanswasthefactthatevenwhenprofitswere negative,manyfinancialinstitutionsproposedpayinglargebonuses. Weshouldrememberthisisnotthefirsttimethatourbankshavebeenbailedout, savedfrombearingtheconsequencesoftheirbadlending.Whilethisisonlythe secondmajorbailoutintwentyyearsintheUS,pastresponsestofinancialcrises 2

abroadinMexico,Brazil,Russia,Indonesia,Thailand,Argentina,andmanyothers werereallybailoutsofAmericanandEuropeanbanks,attheexpenseoftaxpayers inthesecountries,engineeredthroughthebankersalliesattheIMFandtheUS Treasury.Ineachoftheseinstances,thebankshadmadebadlendingdecisions, lendingbeyondtheabilityorwillingnessofborrowerstorepay. Marketeconomiesworktoproducegrowthandefficiency,butonlywhenprivate rewardsandsocialreturnsarealigned.Unfortunately,inthefinancialsector,both individualandinstitutionalincentivesweremisaligned.Theconsequencesofthe failuresofthefinancialsystemwerenotbornejustbythoseinthesectorbutby homeowners,retirees,workers,andtaxpayers,andnotjustinthiscountrybutalso aroundtheworld.Theexternalities,aseconomistsrefertotheseimpactson others,weremassive.Therewerehugeprivateprofitsintheshortrun,intheyears beforethecrisis,offsetbytheevenlargerlossesduringthecrisis.Butthebanksand thebankersreapedthebenefitsoftheformerwithoutpayingproportionatelyfor thecostsofthelatter.AlanGreenspan,inhisfamousmeaculpa,explainedhis misguidedconfidenceinselfregulationhehadassumedthatbankerswoulddoa betterjobinmanagingrisk,indoingwhatwasintheirowninterests.Eventhis diagnosiswasflawed:hewasrightaboutthefailuretomanagerisk,butitwasnot soobviousthatwhattheydidwasnotintheirowninterests.Butallofthismisses therealreasonforregulation.IfIgambleinLasVegasandlose,onlyI(andmy family)suffer.ButinAmericascasinocapitalism,whenthebanksgambledandlost, theentirenationpaidtheprice.Weneedregulationbecauseoftheseexternalities. Sofar,Ihavemadefourkeypoints: 1. Bankshaveconsistentlyfailedtofulfilltheirbasicsocietalmission. 2. Bankshaverepeatedlybeenbailedoutfrombearingtheconsequencesof theirflawedlending. 3. Incentiveswithinthefinancialsystemaredistortedatboththeindividual andinstitutionallevelatbothlevelsprivaterewardsandsocialreturnsare misaligned. 4. Thefinancialsectorhasimposedlargecostsontherestofsocietythe presenceofexternalitiesisoneofthereasonswhythesectorneedstobe regulated. Inprevioustestimony3,Ihaveexplainedwhatkindsofregulationsarerequiredto reducetheriskofadverseexternalities.Ihavealsoexplainedthedangerof excessiverisktakingandhowthatcanbecurtailed.Ihaveexplainedthedangers posedbyunderregulatedderivativemarkets(includingcreditdefaultswaps).I regrettosaythatsofar,morethanayearafterthecrisispeaked,toolittlehasbeen doneoneitheraccount.
Testimony at hearing on The Future of Financial Services Regulation House Financial Services Committee, October 21, 2008.
3

IncentivesandExecutiveCompensation Iwanttofocusmyremainingtimeontheissueofincentivesandexecutive compensation.Therearealsokeyissuesinorganizationalincentives,especially thosethatarisefrominstitutionsthataretoobigtofail,toobigtoberesolved,ortoo intertwinedtofail.Again,Ihavepreviouslytestifiedonthiscriticalissue4,and again,Iregretthatitappearsthatlittleifanythingislikelytobedoneaboutthese institutions.Toomuchattentionhasbeenfocusedonhowtodealwiththe consequencesofafailureoftheseinstitutions;whatisrequiredisprevention: preventingfinancialinstitutionsfrombecomingtoobigtofailortoointertwinedto fail. Theonethingthateconomistsagreeuponisthatincentivesmatter,andevena casuallookattheconventionalincentivestructureswithpaymentfocusedon shortrunperformanceandmanagersnotbearingthefulldownsideconsequences oftheirmistakessuggestedthattheywouldleadtoshortsightedbehaviorand excessiverisktaking.Andsotheydid.Leverageratiosinexcessof30to1meant thatevena4%declineinassetpriceswouldwipeoutaninstitutionsnetworth,and withevensmallerdeclinesabankwouldfailtomeetbasicstandardsofcapital adequacy.Toputthisinperspective:averagehousingpriceshavefallenfromtheir peakbynearly30%. Insomeways,theapparentincentivestructureswereworsethanthis,because compensationtypicallyincreasedwithstockprices,whichprovidedincentivesfor managementtoprovidedistortedinformationthatwouldresultinhigherstock prices.Thebanksexcelledatthis,movingrisksoffbalancesheet,with consequencesthatIhavealreadydescribed.Marketscanonlyworkwellwhen thereisgoodinformation,andthebanksincentivestructuresencouragedthe provisionofdistortedandmisleadinginformation. Moreover,managementwasrewardedforhigherreturns,whetherthosereturns wereproducedmerelybyincreasingrisk(higherbeta,intheparlanceoffinance)or bytrulyoutperformingthemarket(higheralpha).Anyonecandotheformer;the latterisalmostimpossible.Again,nowonderthatallthefinancialwizardstookthe easierrouteanditwasthisexcessiverisktakingthathelpedbringcapitalismto thebrink. Theseproblemsinincentivepayhavelongbeenrecognized.Unlessappropriate careispaidtothequalityofwhatisproduced,thosewhoarepaidonthebasisofthe quantityproducedwillputmoreeffortintoquantitythanquality.Andthatiswhat happenedinfinance;withfeesbased,forinstance,ontheamountofmortgages written,therewaslittleattentionpaidtothequalityofthemortgagesandnot surprisingly,qualitydeterioratedmarkedly,especiallywithsecuritization.
4

Joint Economic Committee hearing on Too Big to Fail or Too Big to Save? Examining the Systemic Threats of Large Financial Institutions, April 21, 2009.

Opportunitiesforproductdeteriorationareespeciallylargeinthefinancialsector, sincetherisksassociatedwith,say,poorermortgages(mortgageswithahigher probabilityofdefault)wontbeevidentuntilyearsafterthefeesareearned.The financialsectorhasbeenparticularlycreativeinfindingaccountingframeworksthat increaseapparentprofitsintheshortrunwithlossesrevealedonlylater.While someoftheaccountingpracticesmayhavegoneoutsidethelaw,therearestill ampleopportunitieswithinthelaw. Thereisanongoingdispute:wasitpoormodels(whichpredictedthateventssuch asthosethatoccurredin20072008wouldoccurlessoftenthanonceinthelifetime oftheuniverse),poorriskmanagement,ortheoffbalancesheetshenanigansthat nearlybroughtdownourbankingsystemandwithittheglobaleconomy?Noneof thesepossibilitiesputsapositivelightonourbankers.Butincentivesplayedakey roleineachoftheseinterpretations.Theyhadanincentivetoengageinexcessive risktaking,theyhadanincentivetoengageindeceptiveaccounting,andtheyhadan incentivetouseandseeminglybelievemodelsthatallowedthemtoundertake excessiverisk.Theyhadanincentivenottoenquiretoodeeplyintothe assumptionsusedinthosemodels.Andtheyhadanincentivenottothinktoo deeplyabouthowtheirincentivestructuresdistorted,andcontinuetodistort, behavior.Andwhiletheycontinuetoemphasizetheimportanceofincentivepay, theyhavebeenslowtoacknowledgethefailingsintheincentivestructuresandto lookforalternatives. 5 Thingsmighthavebeenworsewereitnotforthefactthatmuchofthesocalled incentive(performance)paywasamerecharade:paywashighwhenperformance wasgood,butasthecountrysawin2008and2009,paywasalsohighwhen performancewaspoor.Onlythenameofthepaychanged,e.g.fromincentive bonustoretentionbonus.Studiesinotherdownturnshaveshownthesame pattern.6 Indeed,hadourbankersbeenseriousaboutdesigninganefficientperformance incentivesystem,itwouldhavebeenmarkedlydifferent,withpayrelatedtorelative performance,nottothevagariesoftheoveralleconomyandthestockmarket. Whilethefinancialsectorsfailuretoperformitsessentialfunctions,allthewhile garneringhighprofits,castsapoorlightonthesector,theirpredatorylendingand deceptivecreditcardpracticescastanevendarkershadow.Theyhaveusedalltheir politicalmuscleresistingcurbingthesepractices.Theironyisthatthebankers werehoistedontheirownpetarditwasthesubprimemortgages,irresponsible 5Therehavebeensomeeffortstomakemoreofthecompensationbasedonlongtermperformance,

butlittleefforttoseparateoutperformancewhichisrelatedtobetteralpharatherthanbetaorto outcomesthataretheconsequencesofgeneralmarketfactorsandoutcomesthatarethe consequencesofmanagerscontributions.(Systemsbasedonrelativeperformancecanbeshownto befarbetterthanthosecurrentlyinfashion.See,e.g.B.NalebuffandJ.E.Stiglitz,1983,Prizesand Incentives:TowardsaGeneralTheoryofCompensationandCompetition.BellJournalofEconomics, 14(1):2143.) 6See,forinstance,J.E.Stiglitz,RoaringNineties,NewYork:W.W.Norton,2003.

loansmadetouninformedindividualsbeyondtheirabilitytopay,designedto generatebankersfeesastheyrobbedthepoorofthelifesavings,thatbeganthe unravelingofourfinancialsystem.Ourbankersdiscoveredthattherewasmoneyat thebottomofthepyramid,andtheydideverythingtheycouldtomakesurethatit movedtothetop. Havingdonelittletochangeeithertheincentivesortheconstraintsfacingthe financialsector,wecannotexpectamarkedchangeinbehavior.Ofcourse,inthe immediateaftermathofthecrisis,theyandtheirsupervisorsmaybechastened, thoughatleastforsomeseeminglyfarlessthanonemighthavethought,giventhe enormityoftherecentcalamity. Insomequarters,forinstance,thereisaconcernthatprogramstorestructure mortgageshavegivenrisetonewfees,addedontowhatisalreadyowed.Rather thanareductioninwhatisowed,insomecasesitmaybeincreasing.Recorded profitsandbonusesmayincrease,withlittleregardtotherisksofnonpayment inthefuture. Criticsofregulationworrythatsuchregulationwillstifleinnovation.AsIargued earlier,itishardtoidentifysignificantsocialbenefitsandeasytoidentifylarge socialcostsassociatedwithsomeoftherecentfinancialinnovations.Bankers weremoreinnovativeinfiguringoutwaysofexploitingAmericanconsumersand extractingfeesthantheywereatdesigningproductsthatwouldhelpconsumers managetherisksthattheyface.Theirfailureinthisrespecthashadnotonlyan economiccost,butalsoalargesocialcost:foreclosuresthisyear,estimated between2.5and3.5million,areexpectedtobeevenlargerthaninthelasttwo years. Atthesametime,asIhavenoted,thefinancialsectornotonlyhasnotinnovatedin waysthatwouldhaveloweredtransactioncosts,increasedtheefficiencyofcapital allocation,orledtolesssocietalrisk,butinsomecasestheyhaveevenresistedsuch innovations.Thenewmortgagesledtohigher,notlower,defaultrates:theyclearly madeitmoredifficultforindividualstomanagetheriskofhomeownership.Inmy bookFreefall,Idocumentotherexamples. Noneofthisshouldbeasurprise:flawedincentivesaffectincentivestoinnovate.A betteralignmentofprivaterewardsandsocialreturnsandbetterregulation includingregulationsthataffectincentivestructuresholdsouttheprospectof betterinnovation. Icansummarizeourdiscussionofincentivesasfollows: 1. Flawedincentivesplayedanimportantroleinthisandotherfailuresofthe financialsystemtoperformitscentralroles.Theyencouragedexcessiverisk takingandshortsightedbehavior.Theyencouragedpredatorybehavior. 2. Flawedincentivesalsoexplainthefailureofthefinancialsectortoinnovate inwaysthatwouldhaveservedsocietybetter,e.g.bettermortgagesandan efficientelectronicpaymentmechanism. 6

3. Poorlydesignedincentivesystemscanleadtoadeteriorationofproduct quality,andthishappenedinthefinancialsector.Thisisnotsurprising, giventheampleopportunitiesprovidedbycreativeaccounting. 4. Manyofthecompensationschemesactuallyprovidedincentivesfor deceptiveaccounting.Marketsonlyallocateresourceswellwhen informationisgood;buttheincentivestructuresencourageddistortionsin theprovisionofinformation. 5. Thedesignoftheincentivesystemdemonstratesafailuretounderstandrisk andincentivesand/oradeliberateattempttodeceiveinvestors,exploiting deficienciesinoursystemofcorporategovernance. 6. Therewerealternativecompensationschemesthatwouldhaveprovided betterincentives,butfewfirmschosetoimplementsuchschemes. 7. Mattersmighthavebeenworsebutforthefactthatsomeofthediscussionof incentivepaywassimplyacharade:paywashighwhenperformancewas good,butpaywasalsohighwhenperformancewaspoor.Onlythenameof thecompensationchanged.Therewaslesspayforperformancethan claimed. ConcludingComments Marketeconomiesyieldgrowthandefficiencywhenprivaterewardsandsocial returnsarealigned.Unfortunately,inthefinancialsector,bothindividualand institutionalincentivesweremisaligned.Theresultoftheflawedincentives, perhapsevenworseintheaftermathofthecrisis,canbecalledersatzcapitalism, withlossessocializedandprofitsprivatized;itisaneconomicsystemthatisneither fairnorefficient. Butinsomecriticalways,incentivesareactuallyworsenowthantheywerebefore thecrisis.Thewaythebankbailoutwasmanagedwithmoneyflowingtothebig bankswhilethesmallerbankswereallowedtofail(140failedin2009alone)has ledtoamoreconcentratedbankingsystem.Incentiveshavebeenworsenedtooby theexacerbationoftheproblemofmoralhazard.Anewconceptwithlittlebasis ineconomictheoryorhistoricalexperiencewasintroduced:thelargestfinancial institutionswerejudgedtobetoobigtoberesolved.Wesavednotjustthebanks, butalsothebankers,theshareholders,andthebondholders. Iwanttoendwithtwobroadernotesonthesocietalimpactsofcompensationinthe financialsector.Thefirsthastodowiththeexploitivebehaviorofthoseinthe financialsector,towhichIhavebrieflyreferredearlier.Thebankershavebeen criticizedfortheirexcessivegreed.Firsttimehomebuyersweredeliberately exploited.Similarcriticismscanbemadeabouttheexploitivebehaviorofcredit cardcompanies.Idontthinkthatthosewhowentintofinancearegreedierormore deficientinmoralscruplesthanothers.Buttheincentivestructuresledthemto behaveinthewaythattheydid.Economistshaveanexpression:everyonehas theirprice,andinfinance,fortoomany,therewardsweresimplytoogreatto resist.Thesystemevenaffectedhowtheythought.Inmostprofessionaljobs,one takesprideinoneswork;onegivesonesall.Wedontpayheartsurgeonsonthe 7

basisofsuccess,arguinghigherpaywillprovideanincentivetoexertmoreeffortto savehispatient.Whatkindofpersonsaystohisemployer,Ifyouonlypayme$5 million,Illgiveyouonlyhalfmyeffort?Ifyouwantmetoreallyexertmyenergies, youhavetopaymemoreifIsucceedinincreasingprofits.Butforthoseinfinance, thiskindofreasoningbecamenotonlyacceptablebutalsobecametheconventional wisdomwithlittlethought,aswehaveseen,totherelationshipbetweenthese measuredprofitsandeitherlongtermfirmperformanceor,moreimportantly, societalreturns. Finally,Ihaveemphasizedhowourfinancialsectorfailedinitsessentialsocietal roles,especiallywithrespecttotheallocationofcapital,andhowthesectors incentivestructuresmayhavecontributedtothatfailure.Butthereisanother misallocationofresourcesthatresultedfromthesectorscompensationpolicies, onewhoseeffectsaregraverandlongerlasting,andonewhich,asateacher,Ihave feltintensely.Therewasamisallocationofscarcehumancapital,assomeof Americasmosttalentedyoungsuccumbedtothelureofeasymoneybrilliant mindsthat,inanothereramighthavemaderealdiscoveriesthatenhancedour knowledgeorrealinnovationsthatwouldhaveenhancedsocietalwellbeing.In earlierdecades,ourbeststudentswentintoavarietyofareassomeintomedicine, manyintoresearch,stillothersintopublicservice,andsomeintobusiness.Each foundfulfillmentoftheirpotentialatthesametimetheyservedtheircommunities inonewayoranother.AtAmherstCollege,whereIserveasatrustee,wetalkof helpingouryouthlivelivesofconsequence.Inthismoderneraofafinance dominatedeconomy,unfortunately,adisproportionateshareofourmosttalented youthwentintofinance,luredbytheoutsizedcompensation.Thecoststoour societyofthismisallocationareincalculable.