Saturday, March 28, 2009

Bank Executives' Game

Under current TARP/TALF/PPIF program, the best 'move' for American bank executives is to return TARP money and not to lend to the broader economy. This will postpone recovery and lead to a lose-lose situation. Why so?

If bank executives were to keep TARP money, the U.S. government will have rights to cap executive pay or force them to accept 'sacrifice' on compensation. But we know "moral persuasion" seldom works (don't dream on that). Bank executives will return TARP money even they know a huge mess is still waiting on their balance sheets to deal with. This is the classic principal-agent problem in economics.

So what are the solutions? There are only two alternatives out of this:

1. Obama government temporarily leaves bank executives alone and postpones the plan to cap executive's pay. This will be very difficult in the current anti-Wall Street environment, but it can be done.

2. Obama government overcomes the taboo of nationalization, i.e., take over those "too-big-to-fail" banks and remove bank executives from deciding on their own compensation or even fire them. Government then will force banks to lend to the broader economy. But be reminded the nationalization has to be temporary ---government can never replace private banks in financial markets.

We are living through a period of, I call, "mother of all moral hazards". Government should make a quick calculation on their rescue strategy. Failing to do so will put American economy into real danger and possibly onto the path of Japan-like malaise.

Watch this video from Fortune: