Skewed Incentives

May is a tough month for me, because I have to submit reports for the nonprofits that I work with, and this year is worse, because I have a moderate injury that I need  to see a doctor about, but can’t until next week, because of the schedule.

But I do want to say a few things about the JP Morgan news.  First, JP Morgan should be broken up, whether state by state, or by Federal reserve district, with an investment bank spun off as well.

Second, after we have been through 2008, why do we care about a piddling $2Billion+ loss?  JP Morgan’s balance sheet can handle far more than that, and come back kicking.

Third, there are a lot of people who are mindlessly asking for the reinstatement of Glass-Stegall, without realizing that the repeal had little to do with the crisis.  Most of the losses at banks sprang from bad lending on residential mortgages, not trading.  Also, if regulators had been more fastidious about asset quality and leverage, it also might not have happened, but who dares to oppose a boom?

My point of view is that states are better at regulating financials than the federal government.  It is far harder to co-opt 50 regulators than one.

Decentralized government, where power is limited, is far harder to corrupt than centralized governments like India, China, Russia, Greece, etc.

Fourth, when a bank engages in a complex trade, and is a large portion of the market, it is asking for trouble.  Companies have problems when they become the market for financial promises.  Markets work well when there are a large number of players, with no one dominating.  Financial markets with a dominant player have a problem because it becomes difficult for the dominant player to discern the right price.  They don’t want to set it too low, because it makes their own financials look bad.  That skewed incentive can harm economic truth, and the company as well.

Being a monopolist or an oligopolist is not as easy as the textbooks would say, at least for long-term transactions.  When there is no free market to validate your pricing against, how does an oligopolist come up with an economic price?  It can’t do so.

We get on shaky ground when anyone becomes dominant in a market of promises.  Initially the accounting is flexible enough that losses do not occur on bad lending, but eventually the bad/negative net cash flows crush the firm.  This is why I never invest in novel financial companies.