George Benston The Maverick

1. George BenstonThe Maverick Two landmark events Elections Financial Market Crisis

2. Elections, Financial Crisis, and George • Elections • Both candidates rose to the top against conventional wisdom • Both populists, and one as a self-proclaimed maverick • Both invoke corruption and greed on Wall Street and promise to change Washington • Financial crisis and massive bailout • George: Maverick and at odds with conventional wisdom

3. George and Massive Bailout • Warfare between Wall Street and Main Street • Whose side would George be? • Is the repeal of the 1933 Glass-Stegall Act the culprit? • With the repeal of Glass-Stegall, while banks remained under an explicit regulatory scheme, the other financial institutions were outside the scheme. • What does George say

4. George and Market Solution to Financial Crisis • George would have said that the repeal of the 1933 Act, which got enacted in the wake of the Great Depression crisis, has facilitated market solution • Consider restructuring of Merrill Lynch through ownership transfer to Bank of America • George would have said “let the market take care of itself” • Financial institutions that took risk and benefited from the upside should be left to fail. • George would not have tolerated : “capitalism on the way up and socialism on the way down”.

5. George and Market Solution • Financial distress/bankruptcy does not eliminate viable institutions but only alters ownership • It is that creditors become equity holders, or alternatively holding company can acquire all securities (debt and equity) at prevailing prices and recapitalize the institution. • The institution will continue to function as a viable entity so long as there are productive/profitable opportunities

6. George and Market Solution • On the other hand, if a highly levered institution is not viable, it will fail both financially (goes bankrupt) and economically (goes out of business). • Banks can write down mortgages to the housing value and restructure the debt in a manner that allows the homeowner to continue to pay and continue to occupy the house. • Well, impediments to the market solution? • Crisis of confidence and systemic crisis? • Even then, why not direct capital infusion?

7. George and Regulatory Reform • Moral hazard and excessive risk taking by banks and “Wall Street” institutions • Banks have incentives to take risks beyond what is optimal from the society’s standpoint (e.g., S&L Crisis). • Regulatory response >> George’s idea: Prompt Corrective Action • PCA includes capital rules, asset restrictions and mandatory interventions by regulators • Limitations: inadequacy of capital adequacy; mandatory asset restriction

8. Formalizing bank incentives and deposit insurance effects Bank value V * 1 Value under bank asset risk-shifting V 1 Bank 2 Bank 1 σ σ σ * Risk ( ) 1 1 Figure 2: Bank Investment Opportunities

9. George and Regulatory Reform • George will definitely not support the reenactment of the Glass-Stegall Act! • Need to reform the current regulatory scheme in the face of fallouts from current crisis: • Goldman Sachs and Morgan Stanley as new bank holding companies • Expanded deposit insurance ($250,000) • “Too big to fail” institutions • Incentivized regulation: warrants, bank management compensation as instruments

10. Incentivized Regulation • Warrants have entered a government-sponsored package of workout in the current financial crisis. • They are being used as a compensation for the government bailout. However, they can also be used as incentive mechanisms in controlling risk moving forward and hence mitigating crisis in the future. • Like-wise, the regulatory scheme can also use the incentive features of bank management compensation. By incorporating the parameters of the top management’s compensation in the pricing of the deposit insurance and at the same time leaving the compensation structure itself to the bank’s owners, the regulators can induce bank’s owners to choose the compensation structure that will result in a bank investment policy that is consistent with social optimality.

11. Incentive Features of Management Compensation Compensation Structure: Manager gets a fixed salary S>0, and a fraction α of the equity of the bank. Also a bonus λ, which is increasing in the terminal cash flows realized. α 45o S

12. George and Limits on Executive Pay • The bailout plan, and possibly the regulator reform moving forward, seeks to limit executive pay. • We have seen legislative attempts to curb executive pay before? • George would find this unacceptable and counterproductive • George’s role in the FER and debates on executive compensation reforms • The 1993 Revenue Code eliminating tax breaks for high-level executives' compensation over $1 million, except for “performance-based” component. • Well, it turned out options met the test of “performance-based”. • Unintended consequences: overuse of options (overincetivization of executives)

13. George! • Academic Maverick • Unconventional • Lasting contribution to literature and work that continues to influence policy (current crisis!) • A great friend; Is missed dearly!