Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

When the loans are appropriately classified, Pinto finds that subprime lending alone (including financing through the purchase of mortgage-backed securities) by the mortgage giants and the FHA started at about $85 billion in 1997 and went up to $446 billion in 2003, after which it stabilized at between $300 and $400 billion a year until 2007, the last year of his study.40 On average, these entities accounted for 54 percent of the market across the years, with a high of 70 percent in 2007. He estimates that in June 2008, the mortgage giants, the FHA, and various other government programs were exposed to about $2.7 trillion in subprime and Alt-A loans, approximately 59 percent of total loans to these categories. It is very difficult to reach any other conclusion than that this was a market driven largely by government, or government-influenced, money.

most of the subprime leading up till crisis was govt backed actually

On net, easy credit, as is typically the case, proved an extremely costly way to redistribute. Too many poor families who should never have been lured into buying a house have been evicted after losing their meager savings and are now homeless; too many houses have been built that will not be lived in; and too many financial institutions have incurred enormous losses that the taxpayer will have to absorb for years to come. Although home ownership rates did go up—from 64.2 percent of households in 1994 to 69.2 percent in 2004—too many households that could not afford to borrow were induced to do so, and since 2004, even home ownership has declined steadily (to 67.2 percent as of the fourth quarter of 2009), with the rate likely to fall further as many households face foreclosure.52

easy credit in the end took from the poor and from taxpayers and distributed among the financial sector. (probably not clinton and bush's stated goal ;) )

Rich early developers such as Australia, Canada, and the United States built their complex organizations over time. New industries often started with many small firms, some of which were exceptionally innovative or well managed. These generated larger profits than their competitors, hired more employees, and, over time, built effective and stable organizational structures. Initially, these firms grew slowly, both because it takes time to build the social relationships, the organizational norms, and the organizational procedures that allow the firm to function efficiently and because the availability of outside finance to an untried, unproven organization is limited. Eventually, some firms gained reputation and wealth: many of these were family firms like Anheuser-Busch or Cargill in the United States, whose reputation could transfer down through generations.7 Because banks would accept these firms’ reputation and wealth as collateral for financing, they could grow faster. All in all, however, growth was slow and steady, with many firms falling by the wayside; failure rates for small, new firms are spectacularly high even today.8

nations who develop early in an industry do so gradually without much govt intervention, with fair and trustworthy services and business policies

Daniel Defoe, the businessman, journalist, pamphleteer, and author of Robinson Crusoe, among other books, describes in detail in A Plan of the English Commerce one of the earliest documented instances of government-aided development: the way the Tudor monarchs transformed England from a country reliant on raw-wool exports to one that exported manufactured woolens.10 Prior to his coronation following the War of the Roses, Henry VII spent time as a refugee in the Low Countries. Impressed by the prosperity in those lands, derived from wool manufacturing, he decided to encourage manufacturing in England. The measures he took included identifying locations suitable for manufacturing, poaching skilled workers from the Low Countries, increasing duties on or even banning the export of raw wool, and banning the export of unfinished cloth. The monarchy also started promoting the export of finished woolen garments, with Elizabeth I dispatching trade envoys to the Russian, Mogul, and Persian empires. The calibrated and measured support afforded to industry is best reflected in the fact that raw-wool exports were permanently banned only when the monarchy was confident that domestic manufacturers could use all the raw wool available and were competitive enough internationally to export the additional production. Such managed competition

earliest examples of govt led industrial development . england under henry vii. fostered local wool manufacturing industry through policies that favored local private enterprises. might have picked winners, but imported knowhow, used tariffs and trade blockages (of outgoing raw material) to build competitive local ventures.

The organizational path was less well laid out. Given that the late developers had little faith that their small and underdeveloped private-sector firms could lead growth at a pace that would satisfy their needs, they had two options: they could create government enterprises to undertake business activity, or they could intervene in the functioning of markets to create space for a favored few private firms to grow relatively unhindered by competition. In either situation, the country's savings were directed through a largely captive financial system to the favored few firms. Governments also typically protected their domestic market from foreign imports through high tariffs and import restrictions, allowing domestic firms the space to flourish.

option for late developing nations: state owned enterprises or handpicked 'winners' that receive govt help through investment and policies. few examples of success with SOEs (france, taiwan, soviet union--though in last case claims this progress was not sustainable as it hinged on revolutionary fervor (only lasts so long) and terror)

More generally, the tools used by governments have included erecting barriers to entry, offering tax breaks so that private firms can generate larger profits and use their retained earnings to fund investment, encouraging close ties between banks and favored firms so that the former lend abundantly (and cheaply) to the latter, providing raw materials at a subsidized price, and imposing tariffs so that foreign competition is not a threat. With subsidies and protection from the government, some favored champions have grown rapidly and profitably, acquiring

Summary of the relationship/managed capitalist model. China seems to be doing this well, by virtue of selecting an industry as part of five year plan, other industries (in particular financial) react with knowledge that the blessed industry will flourish, paving the way for cheap credit, success etc. on top of any direct assistance the government gives. (China thought is mine, in case it's incorrect, inapt)

There are, however, a number of problems with government intervention that favors a few. Nothing prevents a corrupt government from distributing favors to incompetent friends or relatives, a problem that has plagued countries like the Philippines. Even if a government starts out with the best intentions and carefully screens incumbents, government protection means that those who become lazy and inefficient are not forced to shut down.

risk of this approach: corruption, failure to remove incompetence.

In sum, the need to create strong firms may lead the state to favor the producer and the financier at the expense of the citizens. As a result, consumption is unnaturally constrained in such economies.

often under these regimes, second problem is that consumption is often suppressed in favor of more production. "we all chip in" etc. all costs to producers are kept low, depressing income for raw materials and overall wages, so no one else has enough income to spend.

One way to both discipline inefficient firms and expand the market for goods is to encourage the country's large firms to export. Not only are firms forced to make attractive cost-competitive products that can win market share internationally, but the larger international markets offer them the possibility of scale economies. Moreover, because they are no longer constrained by the size of the domestic market, they can pick the products for which they have the greatest comparative advantage.

key part of managed model is growth through exports to large economies that can't compete as well on low labor costs. can allow developing nations to pick and choose industries that offer greatest comparative advantage (e.g. ready access to local raw materials)

Developing-country governments tried to enhance incentives even further by offering greater benefits to firms that managed to increase exports. For instance, because foreign exchange was scarce in the early days of growth, imports were severely restricted. Successful exporters were, however, given licenses to import, and the prospect of making money by selling these licenses gave them strong incentives to expand their foreign market share. In situations where foreign countries imposed import quotas, or where raw materials were scarce, the government also allocated a greater share of these to the more successful exporters. So both indirectly and directly, the efficient were encouraged.

incentivize the enterprises that grow exports, e.g. by constraining imports but giving more access to import quota to those growing exports. if they bring in their own foreign currency they can use that themselves. sets up good incentive to be efficient and improve trade (im)balance.

Like Korea or Taiwan, India should have made the switch toward exports and a more open economy in the early 1960s. But because the protected Indian domestic market was large, at least relative to that of the typical late developer, firms were perfectly happy exploiting their home base despite government attempts to encourage exports.

india failed to turn to exports because of relatively large domestic market (didn't strictly need to turn to foreign markets). industry suffered from protectionism against imports an didn't have incentives to improve by needing to compete globally (imports restricted but also other local enterprises suppressed to avoid competing with state firms)

To stay competitive, both countries had to move up the value chain of production and to the frontiers of innovation, making more and more high-tech, skill-intensive products. More important, they also had to improve productivity steadily. They certainly managed to do this in the sectors that exported or competed with imports, the so-called tradable sector. But problems eventually emerged in the domestic nontradable sector, in areas like construction, retail, and hotels, where foreign competition was often naturally absent and sometimes deliberately kept out.

Germany and Japan post-WWII both able to grow rapidly in exportable industries, productivity grew rapidly and were free to compete globally. Non-importable industries (e.g. construction) did not have this same pressure to improve however, so they did not improve as much. Wage growth forced productivity gains and moving up the value chain to the point where they drove innovation in several industries.

As a result, not only are countries like Japan unable to help the global economy recover from a slump, but they are themselves dependent on outside stimulus to pull them out of it. This is a serious fault line. Indeed, an important source of Japan's malaise in the early 1990s was that the United States did not pull out all the customary stops in combating the 1990–91 U.S. recession, and thus did not provide the demand that historically had helped Japan out of its downturns.

Japan never developed domestic market and all growth was dependent on global trends. Japan dependent on US economy to pull Japan out of any slumps.

Chinese households consume even less as a share of the country's income than the typical low average in export-oriented economies.

china at risk of repeating japans path. domestic spending is incredibly low (though clearly has potential for huge domestic market)

The world has thus become imbalanced in a way that markets cannot fix easily: much of my tenure at the International Monetary Fund was spent warning not about finance but about global trade imbalances. The two are linked, for the global trade surpluses produced by the exporters search out countries with weak policies that are disposed to spend but also have the credibility to borrow to finance the spending—at least for a while. In the 1990s, developing countries, especially those in Latin America and East Asia, spent their way into distress. How and why this happened is what I turn to next.

observed pattern: exporters find new markets with weak policies, marked with penchant for spending and creditworthiness to borrow to fund it, until it can't, often crippling the importing market's economy). all caused by and exacerbates global trade imbalance.

Instead of controlling its spending, therefore, the populist government that has exhausted its ability to borrow domestically turns to foreign lenders to finance it. Thus the circumstances in which foreign loans are made are not propitious. Knowing this, foreign lenders demand protection, which the government can typically give only by eroding the rights of existing domestic creditors—for instance, the more the overindebted government borrows in foreign currency, the higher the inflation it will eventually have to generate to erode domestic-debt claims on it. Moreover, because foreign investors make short-term loans, any adverse political development may scare them into refusing to refinance the government. Even more problematic, a substantial improvement in opportunities in their home countries—such as a rise in interest rates—can cause foreign investors to pull their money out en masse.6

developing country households save a lot (and don't spend) because they have no safety nets. thus also reluctant to invest in their govt's debt. cash strapped, govt turns to foreign lenders who have strict terms because of the risk, including repayment in foreign currency. then use inflation to reduce cost of domestic debt (further reducing likelihood of domestic enders) and become heavily dependent on foreign lenders, run big deficits. difficult to get out of and run risk of foreign lenders turning off spigot suddenly (often loans have short durations, plus lender may be enticed by lending in their own economies if interest rates happen to rise there).

For corporations that are young and do not have strong bank relationships—such as the fast-growing but underfunded private sector in China—it may be the only option. Therefore corporations typically invest substantially more only when they grow faster, with their saved profits financing investment. The producer-biased strategy facilitates this kind of growth because the surplus value generated by the economy is allocated directly to producers, enhancing their profits and their ability to invest, instead of winding its way circuitously through households and a financial system that is incapable of lending effectively.

in developing economies, corporations may find it's too expensive to borrow, so investment may be driven by those that are growing the fastest. good for a while but run the risk of growing to overcapacity/till profits disappear (if they don't know when to stop investing) (e.g. East Asian developing countries in the 1990s).

First, the overambitious investments themselves went sour. By early 1997, Alphatec had collapsed under its debts while its memory-chip plant was still under construction. Alphatec itself was only a small family-owned business with very limited experience in the semiconductor industry, and this lack of experience showed. Construction was plagued with delays: the plant was being built on land so marshy that concrete pilings had to be driven down to stabilize the buildings, at great cost. There was no clean water or power, both critical for chip manufacture, so Alphatec had to build the necessary facilities, adding further to costs. And even before high-tech plants like Alphatec's were completed, investors became concerned about their viability and started pulling out. The second trigger was the depreciation of the Japanese yen against the dollar, starting in 1995. This made Japanese exports far more competitive than exports from East Asia, where currencies were linked more closely to the dollar. Rather than sourcing from Thailand, with its uncertain quality and small pool of scientists and engineers, importers around the world now preferred to return to tried and tested Japan. East Asian exports started faltering, corporate profitability plummeted, and investment projects started closing down. Foreign investors started pulling out their money. Speculators joined the frenzy as they saw countries trying to defend exchange rates that were now distinctly overvalued. And as the c...

east asian crisis: companies borrowed from foreign lenders via domestic banks (with implicit guarantee from govt) in foreign currency to fund crazy investment projects not overseen by govt. Prospects went south, local investors pulled out, especially as Yen dropped in value and Japan became cheap supplier again (at lower risk) to markets abroad. Borrowing companies failed, bank failed, govt tried to hold exchange rates fixed, depleting foreign reserves and eventually leading to default or resorting to IMF.

After the crash in the NASDAQ index in 2000–2001 and the recession that followed, the Federal Reserve tried to offset the collapse in investment by cutting short-term interest rates steadily. From a level of 6½ percent in January 2001, interest rates were brought down to 1 percent by June 2003. Such a low level, unprecedented in the post-1971 era of floating exchange rates, sent a strong signal to the economy.

start of a good narrative of the economic history of 2000s

The Fed was now effectively adding stimulus to a world economy that was growing strongly, with jobs being created elsewhere but not in the United States. Commodity prices around the world started a steady rise, suggesting that worldwide economic slack was decreasing. If the Federal Reserve, the world's central banker in all but name, had been focused on sustainable world growth, it should have been tightening monetary policy by raising interest rates. But its mandate covered only the United States.

fed was funding global economic boom in 2000s, commodity prices were rising and global jobs raided significantly while US corporations didn't rehire quickly (prolonged boom before that with too much 'undergrowth'?)

John Taylor of Stanford University has pointed out that even measured against what is known as the Taylor rule (an empirical characterization of past Federal Reserve interest-rate policy, which sees the short-term policy rate as a function of the inflation rate and the gap between the output the economy is capable of and what it actually produces), the Fed should have started raising interest rates by early 2002.

in fact, apparently fed should have started raising rates in 2002, according to Taylor Rule

Ironically, the Federal Reserve's desire to remain independent is the lever with which Congress makes it compliant.

So the Fed was free to focus on the second part of its mandate, full employment. Yet even while the Fed attempted to convince unwilling corporations to invest through ultralow interest rates, the prices of financial assets and housing were skyrocketing. But the orthodoxy suggested asset prices could be ignored.

But history warns that markets such as housing, which are driven by bank lending, are different: not only are they very thin (relatively few house sales determine the value of housing for the whole country), but they also do not allow for investors to take short positions.

interesting point: it's hard to short the housing market, so lots of upward pressure until a crash from massive default

When the stock market eventually crashed in 2000, the dramatic initial response by the Fed ensured that the recession was mild even if job growth was tepid. In a 2002 speech at Jackson Hole, Alan Greenspan now argued that although the Federal Reserve could not recognize or prevent an asset-price boom, it could “mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.”19 This speech seemed to be a post facto rationalization of why Greenspan had not acted more forcefully on his prescient 1996 intuition: he was now saying the Fed should not intervene when it thought asset prices were too high but that it could recognize a bust when it happened and would pick up the pieces. The logic was not only strangely asymmetrical—why is the bottom easier to recognize than the top?—but also positively dangerous. It fueled the flames of asset-price inflation by telling Wall Street and banks across the country that the Fed would not raise interest rates to curb asset prices, and that if matters went terribly wrong, it would step in to prop prices up.

the Greenspan Put: Greenspan failed to act forcefully when he saw asset prices rising too quickly in mid-1990s, and then went to say that the Fed would pick up the pieces if there were a bottoming out. Signal to markets was to take all kinds of risks because there would be financial safety net and no downward pressure on price in the mean time.

“Greenspan put.” It told traders and bankers that if they gambled, the Fed would not limit their gains, but if their bets turned sour, the Fed would limit the consequences. All they had to ensure was that they bet on the same thing, for if they bet alone, they would not pose a systemic threat.

traders had to be /sure/ to gamble to the point of systemic risk, else they wouldn't pose existential threat and be eligible for bailout.

First, it was fixated on the high and persistent unemployment rate and did its best to bring it down by trying to encourage investment. It signaled that it would keep rates low for a sustained period and offered the Greenspan put if firms were still not convinced. Critics should recognize that this fixation was in full accord with its mandate and, more important, that there would have been political hell to pay if it had raised interest rates much earlier than it did.

The Fed was focused on job growth and even feared deflation (rather than worried about inflation), and would have been extremely politically unpopular to raise interest rates more aggressively and earlier.

Somehow the private financial sector contrived to convert its edge into an instrument of self-destruction, for the commercial and investment banks that packaged the mortgages together and sold mortgage-backed securities ended up holding large quantities of them.

In addition to subprime mortgage market, driven by the Fed, govt desire to expand housing, and lots of foreign reserves abroad uninterested in the low interest rates of US treasuries (see: Giant Pool of Money)…banks held on their balance sheets some of the crappy mortgages they were buying and packaging.

Put a sufficient number of subprime mortgages together from different parts of the country and from different originators, issue different tranches of securities against them, and it is indeed possible to convert a substantial quantity of the subprime frogs into AAA-rated princes, provided the correlation between mortgage defaults is low. In normal times, the correlation between residential mortgage defaults is low, because people default only because of personal circumstances such as ill health or because they lose their jobs (for cause, rather than as part of a general layoff). No one really knew what that correlation would be in bad times, when many people might lose jobs because of the poor economy and house prices might fall across the country, making refinancing hard. If the correlation was still low, then the ratings were appropriate. If the correlation was high, then all bets were off— if, for example, the correlation was 1, then the senior securities would default as often as the junior securities, that is 10 percent of the time. The AAA-rated tranches of mortgage-backed securities looked very attractive because they offered a higher return than similarly rated corporate securities. But some should have paid a far higher return because they were in fact very risky. Default correlations were much higher than the rating agencies or investors anticipated. First, the quality of the originated mortgages was low, and many borrowers relied on refinancing as house prices ...

mortgage securitization bundling and tranching can convert risky mortgages into truly AAA investment. but:* loans were crappy and risk of default more like 90% than 10%* models used historical data (when lending was more responsible)* mortgages usually default due to independent personal financial trouble rather than trend across the whole country* mortgages were bundled without nearly enough diversification and they failed in unison, defaults within single bundle were nowhere near independent of one another

second feature of these risks, though, was that systemwide adverse events would be necessary to trigger them: to cause the senior securities to default, mortgages across the country would have to default, suggesting widespread household distress. Similarly, funding would dry up for well-diversified, large banks only if there was a systemwide scare. A third feature, perhaps the most important one from society's perspective, is that these risks are very costly when they are realized, so they should not be ignored despite their low probability. Unfortunately, these very features of systemic tail risks ensure that they are ignored by both financial firms and markets.

ignored or counted upon: catastrophe brings in the feds. they may have needed to ensure systemic risk to be able to safely "ignore"…or just count on being able to run the racket for 4 or 5 years to collect enough to retire even if followed by firm's or economy's collapse.

When bankers attribute their problems to an unlikely event akin to a one-in-ten-thousand-year flood (thereby implicitly absolving themselves, for who could anticipate such a rare event?), they neglect to mention that their actions have increased the probability of such an event—to

good point

Failing in a herd rarely has adverse consequences.

But the returns are high, because people are willing to pay a lot to avoid being hit by cataclysmic losses in bad times.

The most obvious factor driving this behavior seems to be the compensation system, which typically paid hefty bonuses when employees made profits but did not penalize them significantly when they incurred losses.

Or better, penalized for taking undue risk or for having low risk-adjusted returns. Should someone be rewarded for taking imprudent risk and getting lucky? Over the course of a career, one could make a lot of money as long as one of 10 risky bets pays off well for long enough time. Should that be allowed/encouraged?

The profitable one-sided bet this offered employees was known variously as the Acapulco Play, IBG (I’ll be gone if it doesn't work), and, in Chicago, the O’Hare Option (buy a ticket departing from O’Hare International Airport: if the strategy fails, use it; if the strategy succeeds, tear up the ticket and return to the office). That such strategies were common enough in the industry as to have names suggests that not all traders were oblivious to the risks they were taking.

Acapulco Play, IBG, O'Hare Option: have an escape plan in place in case things blow up.

Risk managers should adjust every unit's returns down for the risk it takes, reducing perverse incentives to take risk.

were some thinking that they were doing it and just underestimating the known risk? using a normal distribution vs fat tail distribution?

In many of the aggressive firms that got into trouble, risk management was used primarily for regulatory compliance rather than as an instrument of management control.

believe that

When a CEO adjudicated a dispute between his star trader, who had produced $50 million in profits every quarter for the past ten quarters, and his risk manager, who had opposed the trader's risk taking all along, the natural impulse would be to side with the trader. The risk manager was often portrayed as the old has-been who did not understand the new paradigm—and the risk takers had the track record to prove it.

This is kind of what scares me the most: Who is actually motivated to keep the firm afloat vs taking on bets against very unlikely but disastrous events? not CEO, not shareholders (most at least, who want to see earnings especially vs competitors), certainly not those compensated immediately for taking on the risk. maybe the risk management team is the only group in any sort of position of relevance who are motivated to keep rm afloat or decades… but even within that role there's certainly opportunity to shut up and get big bonuses for a few years, especially if that wins favor with executives (and thus promotion, bigger bonuses etc.).And if few or no one in actual power is incentivized to keep firm afloat, who is motivated to keep the entire economy healthy?

But if that were the case, then the blame for encouraging the bet-the-firm tail risk taking that was going on must lie with top management.

They're probably the least likely to take a stance though, unless out of some deep-seated loyalty to that particular firm. They could always go somewhere else and start again

However, an intriguing study suggests that bank CEOs in some of the worst-hit banks did not lack for incentives to manage their banks well.8 Richard Fuld at Lehman owned about $1 billion worth of Lehman stock at the end of fiscal year 2006, and James Cayne of Bear Stearns owned $953 million. These CEOs lost tremendous amounts when their firms were brought down by what were effectively modern-day bank runs. Indeed, the study shows that banks in which CEOs owned the most stock typically performed the worst during the crisis. These CEOs had substantial amounts to lose if their bets did not play out well (no matter how rich they otherwise were). Unlike those of some of their traders, their bets were not one-way.

interesting

In Trillin's time in college, only those in the bottom third of their university class used to go on to Wall Street careers, which were boring and only moderately remunerative. But even while the dullards ascended to the top positions at the banks, Wall Street became a more exciting and challenging place, paying people beyond their wildest dreams. It started attracting and recruiting the smartest students in class, people who thought they could price CDO squared and CDO cubed (particularly egregious forms of securitization involving collateralized debt obligations) and manage their risks. As Trillin writes: “When the smart guys started this business of securitizing things that didn't even exist in the first place, who was running the firms they worked for? Our guys! The lower third of the class! Guys who didn't have the foggiest notion of what a credit default swap was. All our guys knew was that they were getting disgustingly rich, and they had gotten to like that.”

Hypothesis that top management at banks in 2000s were all starting careers when Wall Street took the poorer performing students out of college so they weren't that smart. But then Wall Street got cool and younger geniuses started working for these dullards who didn't know what the whizzes were doing so top management were actually just incompetent. Maybe, but seems unlikely. Would guess that CEOs and other top managers are still well above mean (even if the mean of those going to Wall Street in their cohort was below average overall...you've got to be somewhat smart to rise to the top, right?)

In a sense, therefore, regulators inadvertently pointed banks toward these securities. In some ways practices like this are an unavoidable consequence of regulation. If banks have an incentive to take risk, they will always look for opportunities to get the greatest bang for the regulatory buck. But the regulatory mistake of requiring too little capital for certain activities is then compounded because in taking advantage of regulatory mistakes, banks build up exposure to the same risks. The dynamic associated with systemic risk exposures then kicks in: if everyone is exposed to the same risk in a big way, the authorities have no option but to intervene to support banks and the market if the risk materializes—in which case a bank maximizes profits by increasing exposure to the risk.

regulators can push banks to all take the same risk if capital requirements are out of sync with the risk premium that the market shows, compounding the systemic risk

Ironically, faith in draconian regulation is strongest at the bottom of the cycle, when there is little need for participants to be regulated.

elizabeth warren

By contrast, the misconception that markets will govern themselves is most widespread at the top of the cycle, at the point of maximum danger to the system.

alan greenspan

there are huge incentives at every level in the financial system to take on these tail risks if they can be concealed from those assessing performance. Those giving up the tail risk are willing to pay a premium to do so, while those taking it on and downplaying the eventual risk of payout can treat the premium as pure profit, the product of their natural brilliance rather than merely a compensation for risk. The premium paid by those selling the risk increases in proportion to the anticipated loss if the risk actually hits (they pay more if they think earthquakes will do more damage); and the higher the premium, the more of the risk the sellers are willing to take on (because they do not anticipate being around when their firms have to make good the loss). Too many firms will be eager to take on risks that have extremely costly consequences, and they will compete to take the risk at too low a price. The net result is that too much of the risk will be created.

One way to make units internalize small-probability tail risks that senior management or risk managers may not see or understand is to hold a significant part of a unit’s bonuses in any year in escrow, subject to clawbacks based on the unit’s performance in subsequent years—a suggestion I made before banker bonuses became a political football.

But for how long? Till financial products resolve themselves (and tail risk gone completely)? Is this feasible? Will it distort behavior as well? I guess it could reduce the systemic risk, but the bonus is so small compared with the actual risk, the bonuses won't cover the shortfall. Still motivates traders to take huge risks because on average some will pay off big. Hold all in escrow until retirement? Won't happen. But even if it did, enough times the risks will luckily not materialize and they'll be able to cash in big.

Boards can be strengthened by requiring more financial services expertise of directors, as well as by drawing them from outside Wall Street. Furthermore, a board can obtain better information if the risk managers in the firm are required to report directly to it on a regular basis. The board’s risk committee should also have regular meetings to discuss firmwide risk with unit heads across the firm, without top management present, so that they have a sense of what is going on from those who are closest to the action. Of course, if competent boards are propelled by the same risk-taking incentives as top management, we will have to look elsewhere for ways to discipline risk taking.

I have trouble seeing regulation to force this. And very unlikely to be done voluntarily.

If interest rates move up substantially on a large portion of the financial firm’s debt when it takes more risk, thereby reducing profits, both management and the board may be deterred from risky behavior.

Big if. How are lenders going to know how much risk its borrowers are exposing themselves to?