Friday, October 5, 2012

Overleverage, And Faulty Incentive System Caused Financial Crisis

This article was written in response to an article by Andy Haldane who argued the central bank dependence on DSGE models contributed to the financial crisis.  The use of leverage by banks expanded rapidly during the crisis and the failure of regulators to deal with increasing leverage was a more important problem.  It may be more important to examine the political economy of deregulation and the incentive systems in banks that rewarded bankers for achieving short term financial targets.

There are problems with central bank reliance on DSGE models which view credit expansion as exogenous to the real economy.  I tend to agree with Mainly Macro, however, that deregulation and the use of leverage to maximize short term performance and bonus's was more important.  There was a failure of corporate governance throughout the global banking system.  Little has been done to reduce the threat of future financial crises from poor corporate governance.  They still operate under an asymmetric incentive system that provides huge rewards for short term performance, and weak penalties for management risk taking on the downside.

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