Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint

Contract theory’s insight into the financial crisis

In the financial sector, participants have not always been able to design optimal contracts

The decision to award the 2016 Nobel Prize in economics to Bengt Holmström and Oliver Hart for their contribution to contract theory acknowledges the progress in perhaps the most important aspect of the working of a market economy.

The modern economy cannot function without cooperation among economic agents that backed by contracts of one kind or another. But the problem arises when parties entering into the contract are driven by different kinds of incentives and have a conflict of interest. The objective of the contract theory is to help economic agents design better contracts which will bring in more efficiency in the working of a market economy. This is where the work done by Holmström and Hart becomes useful—and market participants would do well to learn from academic work in the area as it evolves. There is still a lot of ground to cover.

Recently, Deutsche Bank was fined by the US authorities for mis-selling securities in the run-up to the financial crisis of 2008. Some other financial institutions have also been fined in the past for their role in the crisis. In fact, the financial crisis and its aftermath was an example of how incentives can get misaligned at various levels. One aspect of the problem is that the manager of a business (the agent) and shareholders (the principal) might have different goals. A standard problem in contract occurs when the principal cannot directly monitor the agent’s action, which can lead to moral hazard as the agent might work in his own interest. This is exactly what happened in several parts of the developed world, leading ultimately to the financial crisis. Among other things, managers in the banking and financial sector were taking excessive risk in order to show higher quarterly earnings and boost stock prices. Since the compensation was linked to profits, and the value of stock options to share prices, there was very little incentive to think about the long term.

Citigroup’s then chief executive, Charles Prince, in an interview to Financial Times in 2007, famously said: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing." It is becoming increasingly clear that top managers in the financial sector knew that the banks they manage were taking excessive risk. A recent paper by the London-based Centre for Economic Policy Research highlighted that top executives in the banking sector were aware of the consequences of excessive risk-taking and sold their own shares before the crisis. “...given the informational content of bank insider trading before overall real estate problems, our results suggest that insiders understood the large risk-taking in their banks, they were not simply over optimistic, and hence the insiders in the riskier banks sold more before the crisis," the study noted. It also says that the evidence is consistent with the agency problems in the banking sector.

Agency problems in corporations are not new and Holmström’s work over the years, for example, flagged such issues. His multi-tasking model shows that if the pay of a manager is linked to the outcome in the short term, he may neglect the long-term interest of the company. Holmström’s 1991 paper, Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, And Job Design, written with Paul Milgrom, says: “...short-term incentives for employed managers must be muted to prevent them from allocating their attention away from important, but hard to measure, asset values."

It’s not that only the incentive to maximize pay in the short run affects the behaviour of a manager. In a paper, Managerial Incentive Problems: A Dynamic Perspective, published in 1999, Holmström argued that the career concerns of the manager also determine risk preference. “Perceptions about talent...determine the manager’s future opportunity wage and this is what makes investments risky from the manager’s perspective even if income is not explicitly tied to profits," the paper noted. This means that a manager may be taking a decision which is not in the best interest of the company.

Experience in the marketplace suggests that participants have not always been able to design optimal contracts, especially in the financial sector, that align incentives for all parties in order to reduce moral hazard and risks. Therefore, the financial sector needs to evaluate the way contracts are designed, as it not only affects company shareholders but also financial stability. Greater regulatory oversight of incentives to managers in the financial sector would also be required.

India has a lot to learn in this regard. With the growing size of the economy and increasing dependence on market forces, complexities in the financial sector or the economy in general will only increase. India can also gain from the theory of the incomplete contracts developed by Hart and others, for it is not easy to write and enforce contracts in the real world all the time. This may be relevant in the area of the public-private partnership and long-gestation infrastructure projects. Allocation of control rights and specifying which party can take decisions in a particular condition can lead to better outcomes.

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