It Takes A Village To Maintain A Dangerous Financial System

Anat R. Admati

Stanford Graduate School of Business

May 1, 2016

Forthcoming in Just Financial Market: Finance in a Just Society, Lisa Herzog, Editor, Oxford University Press, 2016

Rock Center for Corporate Governance at Stanford University Working Paper No. 219

[drizzle]Abstract:

I discuss the motivations and actions (or inaction) of individuals in the financial system, governments, central banks, academia and the media that collectively contribute to the persistence of a dangerous and distorted financial system and inadequate, poorly designed regulations. Reassurances that regulators are doing their best to protect the public are false. The underlying problem is a powerful mix of distorted incentives, ignorance, confusion, and lack of accountability. Willful blindness seems to play a role in flawed claims by the system’s enablers that obscure reality and muddle the policy debate.

It Takes A Village To Maintain A Dangerous Financial System – Introduction

“If it takes a village to raise a child, it takes a village to abuse a child.”

The financial system is meant to facilitate efficient allocation of resources and help people and businesses fund, invest, save and mange risks. This system is rife with conflicts of interests. Reckless practices, if uncontrolled by market forces and effective rules, can cause great harm. Most of the time, however, the harm from excessive risk in banking is invisible and the culprits remain unaccountable. They rarely violate the law.

In this chapter I focus on the excessive use of debt in banking that creates unnecessary fragility and distortions. The Great Financial Crisis of 2007-2009 exposed the ineffectiveness of the relevant regulations in place at the time. Yet even now and despite the crisis, the rules remain inadequate and flawed. Policymakers who repeatedly fail to protect the public are not accountable partly because false claims obscure reality, create confusion and muddle the debate.

It is useful to contrast safety in banking and in aviation. Tens of thousands of airplanes take off, fly and land daily, often simultaneously within small geographical area. Yet, crashes are remarkably rare. It takes many collaborating individuals, from engineers and assembly workers to mechanics, airline and airport employees, air controllers, and regulators, to achieve and maintain such safety levels. In banking, instead, there are strong incentives to take excessive risk; banks effectively compete to endanger. The victims are dispersed and either unaware of the endangerment, misled into believing that the risk is unavoidable or that reducing it would entail significant cost, or powerless to bring about meaningful change. Most of those who collectively control the system benefit from its fragility or choose to avoid challenging the system, effectively becoming enablers.

Society’s interest in aviation safety is aligned with the incentives of those involved in maintaining it. Crashed planes and dead passengers are visible to the public and easy to understand. Airplane manufacturers and airlines stand to suffer losses from compromising safety. Radars, flight recorders and other technologies uncover the exact cause of most plane crashes, and those responsible face consequences. Screening procedures try to prevent terrorist attacks. The fear of being directly responsible for deaths prevents individuals involved in maintaining safe aviation from failing to do their part.

In banking, the public interest in safety conflicts with the incentives of people within the industry. Protecting the public requires effective regulations because market forces fail to do so. Without effective regulations, dangerous conduct is enabled and perversely rewarded. Because the harm is difficult to connect to specific policy failures and individuals, it persists. Even if a crisis occurs, the enablers of the system can promote narratives that divert attention from their own responsibility and from the fact that much more can be done at little if any social cost to make the system safer and healthier. The narrative that crises are largely unpreventable shifts attention to emergency preparedness and away from better rules to reduce the frequency of emergencies in the first place.

Compromising safety when accountability is diffuse is not unique to finance. In a recent example, General Motors failed to recall cars with faulty ignition that could cause fatal accidents. Many employees knew about the problem, yet failed to act to prevent the harm. The corporate culture promoted silence, obfuscation and unaccountability, and there were strong incentives to cut costs and sacrifice safety (see Valoukas 2014 for an extensive analysis).

Harm and endangerment might be denied and obscured for extended periods of time. Tobacco companies denied the addictiveness of nicotine and the harm from cigarettes for decades (see e.g. Nestle 2015 and Oreskas and Conway 2010). The U.S. National Football League spent years denying the harm from concussions (see Fainaru-Wada and Fairaru 2013 on the “league of denial”). Companies selling children’s products sometime endanger lives by compromising safety and obscuring known problems even after dangerous products are recalled (Felcher 2001). In some cases, overwhelming evidence eventually exposes the truth, as happened for cigarettes.

Governments have the role of creating and enforcing rules for the safety of roads, buildings, water, air, foods, medicines, etc. When governments fail in this role, the results can be devastating. One example is the preventable nuclear disaster in Japan in 2011. Despite a report that exposed the deep regulatory capture at the root of the disaster, little has changed since (see Ferguson and Janson 2013 and Green 2015). In 2014, the U.S. Department of Veterans Affairs was rocked with a scandal involving phony wait times that delayed access to treatment and benefits to many eligible veterans. It has struggled with accountability issues since (Boyer 2016). In a recent scandal in the U.S., lead-contaminated water flowed for months into the town of Flint, Michigan, causing serious and long-lasting health problems for many. State officials had ignored and failed to respond to repeated complaints. Michigan law shields decision-makers from public scrutiny, making it difficult to hold individuals responsible for the harm accountable (Clark 2016).

It Takes A Village To Maintain A Dangerous Financial System

See full PDF below.

[/drizzle]