Banks Act Irrationally in the Name of Competition

I'm in the midst of reading former Treasury Secretary Hank Paulson's book "On The Brink." It's pretty fascinating so far on several levels, but I'm only about a hundred pages in.* The other night, I came across a passage that I found profoundly troubling. It demonstrates all too clearly the lack of economic leadership exhibited by bank management. Rather than making intelligent decisions, they look for the government to regulate them.

The story I'm referring to starts on page 69. The context is Paulson's discussion of how there was too much leverage in the financial system. That was partially caused by a massive credit bubble, which extended far beyond just the mortgage market. He had a discussion at a dinner at the New York Fed in June 2007 with the heads of some of Wall Street's biggest banks. They were complaining about so-called "Covenant-lite" loans, where bankers eased restrictions to allow borrowers (like private equity firms) more flexibility on repayment. Paulson writes:

Chuck Prince, the Citigroup CEO, asked whether, given the competitive pressures, there wasn't a role for regulators to tamp down some of the riskier practices. Basically, he asked: "Isn't there something you can do to order us not to take any of these risks?"

Not long after, I remember, Prince was quoted as saying, "As long as the music is playing, you've got to get up and dance."

This strikes me as sheer lunacy. Several other banks decided to stop making these covenant-lite loans, but by the time they did, it was already too late. Yet, banks felt "pressured" to continue making them. What does this mean exactly? If they believed that these loans were dangerous and a poor practice, why would it matter how much pressure they felt from competition? I'd challenge Prince's analogy: if you don't like the music that's playing, you don't have to dance to it. Doing so will just make you look foolish.

I can't get over the fact that banks would knowingly do something they believed would harm them. That's sort of like saying, "Gosh everyone else is eating rat poison. We'd better too!" And then saying, "Geez, this rat poison isn't good for us -- but it's so delicious that we just can't help ourselves. Maybe the government can make rat poison illegal so we won't have to eat it anymore." Right, or you could just use your senses and stop eating it since it will eventually kill you. After all, then when the rest of your competition is dead, you'll be alive and thriving.

It's crazy to say that the government should step in and stop banks from doing something that they recognize to be stupid. The government shouldn't have to. The leaders of the banks should heed prudent risk management and refuse to make bad loans that they think will lead to huge losses. In doing so, they will, in fact, have an advantage over their competitors who will incur deep losses due to their poor choices.

Competition isn't about acting like sheep and just following the flock -- it's about outsmarting others. If banks recognizes that a loan product is harmful, then there's no rational pressure that can encourage them to continue selling it.

I found this passage very disturbing. I'm a strong advocate for providing business as much freedom as reasonable, but that only works if their leaders act rationally. This episode reveals that they don't. They knowingly act irrationally in the name of competition, while hoping the government will save them from themselves through regulation. If these are the industry's leaders, then it's no wonder the financial industry is so screwed up.

* I have this annoying habit of reading at least three books at once, so it takes me forever to get through one. So expect more posts about this book in the weeks (not days) to come.