Edward Kane is a research professor of finance at Boston College, and former president of the American Finance Association, a national association of finance professors. Ed wrote two books warning us about the savings and loans/deposit insurance crisis in the 1980s, before we really knew what hit us. Ed is a wonderful speaker and master of metaphor.
One of his metaphors has ‘gained currency’ (popular use). Ed was the person who coined the term ‘zombie bank.’ The ‘zombie’ term refers to effectively-insolvent financial firms that are not resolved by regulatory authorities and allowed to stay open, staying afloat with explicit and/or implicit public guarantees for their liabilities. When the zombies are allowed to roam about with the living, they have incentives to take higher risks, given that the public—and taxpayers—hold the downside.
To get to know the depth and breadth of this remarkable person, you can rely on the horse's mouth.
Ed has developed some innovative if not radical and useful ideas about accounting and fiduciary duties in “too big to fail” (TBTF) financial firms. Taking note of the implicit equity stake of taxpayers (and on the downside), Kane has called for recognizing taxpayer equity in TBTF firms, together with coupling a fiduciary duty to taxpayers along with traditional manager duties for shareholders. In his view, TBTF managers working for shareholders effectively assume a duty to take higher risk on taxpayers’ dimes, and these incentives can pollute the waters for taxpayers. (See this related interview with Ed, titled “How is Jamie Dimon like a Smoker on an Airplane?”).
A new article coming out at the Journal of Corporate Finance develops empirical evidence underlining Kane’s concerns. In “CEO Compensation and Risk-Taking in Financial Firms: Evidence from US Federal Loan Assistance,” Amar Gande and Swaminathan Kalpathy look closely at emergency loans the Fed provided to banks during the 2007-2009 financial crisis, and in light of equity incentives in bank CEO compensation. After looking carefully, they conclude that equity incentives were indeed associated with higher risk-taking.
Why should we care about this stuff? Well, besides the fact that we don’t want to relive old lessons available from past financial crises every other decade? Here are three related reasons to care:
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Consider the implications of recognizing taxpayer equity in TBTF balance sheets. Among other things, this would imply that we should consider recognizing investments in TBTF banks (and related dividends) in the federal government’s financial statements.
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TBTF banks are not the only parties with a public safety net potentially available to them. Many pension plans are woefully underfunded, including “private” plans backed by the federal government’s Pension Benefit Guaranty Corporation, as well as state and local government pension plans. Many of these plans have risky investment portfolios, possibly driven in part by the same types of incentives for managers of TBTF banks.
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There is a unique set of banks arguably in the TBTF category. They are the 12 Federal Reserve Banks. These banks have grown rapidly in the last decade and are highly leveraged. The Reserve Banks have "shareholders.” There are important qualifications to the ability of those shareholders to influence risk-taking behavior of the managers of the Reserve Banks, which include the Board of Governors of the Federal Reserve as well as, ultimately, Congress. But thinking creatively, one could consider there is an informal but powerful control group behind the massively increased risk on the Federal Reserve Bank balance sheets, holding a form of “we capture the upside, taxpayers get the downside” payoff structure threatening taxpayers.