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Delamaide: Nobel economist talks tough on banks

usatoday.com | October 20, 2014

By Darrell Delamaide

WASHINGTON — Governments need to intervene to "tame" giant firms in banking and other industries where a few companies dominate the sector, according to the latest Nobel Prize winner.

"The science of taming powerful firms" is the way the Nobel Prize committee this week summed up the research on government regulation by the newest laureate in economics, Frenchman Jean Tirole.

Classic economics teaches us that competition will normally make companies act in the public interest because they will strive to succeed by delivering high quality at low cost.

"But many industries are not very competitive, and this lack of competition widens the scope for beneficial public intervention," the prize committee said in its citation for Tirole, who is affiliated with the University of Toulouse.

Tirole's research, the committee said, shows that government regulation becomes more necessary because big firms dominating a market know more about it than anyone else — what economists call asymmetry of information.

Although he has studied numerous industrial sectors, from telecoms to information technology, Tirole himself left little doubt this week as to how his theories apply to banking.

"We need strong regulations that are going to prevent banks from gambling with taxpayer money," Tirole said in a telephone interview with Bloomberg Television after the announcement of his award on Monday. "Regulations are not about preventing banks from functioning. Actually it's the reverse — regulations are about the rules of the game and an independent enforcement of the rules of the game."

Tirole thought it was too early to tell if new regulations adopted in the wake of the financial crisis will be effective in preventing another one, though he applauded the emphasis on liquidity risk in the banks and the attention being paid to their trading partners.

"The main thing is to get banks not to take too much risk," Tirole said in the television interview.

The Nobel Prize in Economics, won by a French citizen only once before, was awarded for the body of Tirole's work, both on individual issues and for providing a robust theoretical framework for understanding regulation.

In a paper published last year in collaboration with Princeton University's Roland Bénabou, however, Tirole zeroed in on the specific issue of how compensation in banking and other industries can actually undermine companies by giving the wrong kind of incentives to top people to feather their own nests.

"Large bonuses and salaries are needed, it is typically said, to retain talent and top performers in finance, corporations, medicine, academia, as well as to incentivize them to perform to the best of their high abilities," the authors comment in noting the explosion in pay for top managers.

"The result is a 'bonus culture' that takes over the workplace," these academics conclude, "generating distorted decisions and significant efficiency losses, particularly in the long run."

Thus, the trend to higher compensation "has been accompanied by mounting revelations of poor actual performance, severe moral hazard and even outright fraud," they say, in what perfectly describes the history of banking in the past decade.

The two economists describe long-term consequences that fit many big banks, from the need for bailouts to such setbacks as large trading losses, declines in stock value, loss of reputation and consumer goodwill, regulatory fines and legal liabilities, or even bankruptcy.

Ironically, one of the top U.S. bank regulators, Federal Reserve Board governor Daniel Tarullo, used similar language at an event held in conjunction with the International Monetary Fund meetings last weekend in Washington.

Tarullo, who heads up the Fed's regulatory activities, responded to a question about "conduct and culture" at the banks in a conversation with Tim Adams, chief executive Institute for International Finance, a group representing the big global banks.

"The problem at this juncture is that there are so many problems," Tarullo answered, citing a litany of bank scandals from mortgage fraud to cheating on the Libor benchmark interest rate to the latest probe of underhanded dealings in foreign exchange.

"You can't just be telling yourself it's a few bad apples," Tarullo said. "There is something about the structure of incentives and expectations within firms that needs to be addressed."

Tarullo said he thinks a lot of boards and management know the problem needs to be addressed. But he also said regulators have to set expectations for banks on issues of compensation as well as risk and other parameters.

But limits on compensation have received little attention so far from regulators, including the Fed. Perhaps this week's Nobel Prize will prompt Tarullo and others to study Tirole's research more closely and take tougher action.

USA TODAY columnist Darrell Delamaide has reported on business and economics from New York, Paris, Berlin and Washington for Dow Jones news service, Barron's, Institutional Investor and Bloomberg News service, among others.


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