Here is an example of what we've been referring to as the agency problem or the conflict of interests that may result from different incentives guiding diverse economic actors or as defined by wikipedia.org "treats the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent, such as the problem that the two may not have the same interests, while the principal is, presumably, hiring the agent to pursue the interests of the former".
Gretchen Morgenson and Louise Story of the New York Times brings to spot a possible case, (bold emphasis mine),
``Goldman was not the only firm that peddled these complex securities — known as synthetic collateralized debt obligations, or C.D.O.’s — and then made financial bets against them, called selling short in Wall Street parlance. Others that created similar securities and then bet they would fail, according to Wall Street traders, include Deutsche Bank and Morgan Stanley, as well as smaller firms like Tricadia Inc., an investment company whose parent firm was overseen by Lewis A. Sachs, who this year became a special counselor to Treasury Secretary Timothy F. Geithner.
``How these disastrously performing securities were devised is now the subject of scrutiny by investigators in Congress, at the Securities and Exchange Commission and at the Financial Industry Regulatory Authority, Wall Street’s self-regulatory organization, according to people briefed on the investigations. Those involved with the inquiries declined to comment.
``While the investigations are in the early phases, authorities appear to be looking at whether securities laws or rules of fair dealing were violated by firms that created and sold these mortgage-linked debt instruments and then bet against the clients who purchased them, people briefed on the matter say."
Read the entire article here.
Meanwhile Professor Arnold Kling of econolib.org makes a good explanation (bold emphasis mine),
``One difference is that financial innovation often serves the purpose of regulatory arbitrage--devising an instrument to comply with the letter of regulation while evading its spirit. Another difference is that financial innovation often is used by clever Wall Street bankers to separate less sophisticated investors from their money. In that sense, it is sort of like innovation in stealing credit card information. In the case of bankers outsmarting their clients, you can blame the victims for failing to be wary or to protect themselves."
The obvious lesson is that people's actions are impelled by divergent incentives whether it be motivated by regulatory arbitrage, profits, innovation, reputation and etc...
The second lesson is that divergence could mean conflict of interests; the cost -benefits and risk-reward tradeoffs, aside from information or knowledge can be asymmetric and opposite to the interests of the other party.
Third, while the article's innuendo is one of 'market failure' via misrepresentation, the fact is that regulators themselves have different incentives from the private or non-public economic actors which could lead to myriad forms of conflicts of interest. In other words, trying to forcibly align incentives by means of added regulations will likely lead to more distortions and/or unintended consequences.
The fact that regulatory arbitrage exists, which could be construed as a cat-mouse dynamic, is a manifestation of how private economic actors work to always circumvent current regulations.
Also, the fact that regulatory capture is stereotyped mostly in industries that are heavily regulated implies that many economic actors collude with regulators (or politicians) to "game" the system (example, monopolies, special licensing, private-public partnership and etc...).
Fourth, it is also true that with the growing sophistication of markets, diversified security instruments may be used for hedging, than simply a one-direction trade, often seen in underdeveloped markets. Hence, unless governments opts to bring society, as represented by the markets, back to the medieval ages, the question of conflicts of interest could be contentious and signify as controversial gray area.
Lastly, the ultimate lesson is nailed by Professor Kling, "you can blame the victims for failing to be wary or to protect themselves."
This means that without understanding the incentives driving the source of your information or those whom you do business with, you can increase your risks.
``Risk comes from not knowing what you're doing” warns Mr. Warren Buffett, we'd further improve "risk comes from not knowing the incentives with those whom you are dealing with"
Gretchen Morgenson and Louise Story of the New York Times brings to spot a possible case, (bold emphasis mine),
``Goldman was not the only firm that peddled these complex securities — known as synthetic collateralized debt obligations, or C.D.O.’s — and then made financial bets against them, called selling short in Wall Street parlance. Others that created similar securities and then bet they would fail, according to Wall Street traders, include Deutsche Bank and Morgan Stanley, as well as smaller firms like Tricadia Inc., an investment company whose parent firm was overseen by Lewis A. Sachs, who this year became a special counselor to Treasury Secretary Timothy F. Geithner.
``How these disastrously performing securities were devised is now the subject of scrutiny by investigators in Congress, at the Securities and Exchange Commission and at the Financial Industry Regulatory Authority, Wall Street’s self-regulatory organization, according to people briefed on the investigations. Those involved with the inquiries declined to comment.
``While the investigations are in the early phases, authorities appear to be looking at whether securities laws or rules of fair dealing were violated by firms that created and sold these mortgage-linked debt instruments and then bet against the clients who purchased them, people briefed on the matter say."
Read the entire article here.
Meanwhile Professor Arnold Kling of econolib.org makes a good explanation (bold emphasis mine),
``One difference is that financial innovation often serves the purpose of regulatory arbitrage--devising an instrument to comply with the letter of regulation while evading its spirit. Another difference is that financial innovation often is used by clever Wall Street bankers to separate less sophisticated investors from their money. In that sense, it is sort of like innovation in stealing credit card information. In the case of bankers outsmarting their clients, you can blame the victims for failing to be wary or to protect themselves."
The obvious lesson is that people's actions are impelled by divergent incentives whether it be motivated by regulatory arbitrage, profits, innovation, reputation and etc...
The second lesson is that divergence could mean conflict of interests; the cost -benefits and risk-reward tradeoffs, aside from information or knowledge can be asymmetric and opposite to the interests of the other party.
Third, while the article's innuendo is one of 'market failure' via misrepresentation, the fact is that regulators themselves have different incentives from the private or non-public economic actors which could lead to myriad forms of conflicts of interest. In other words, trying to forcibly align incentives by means of added regulations will likely lead to more distortions and/or unintended consequences.
The fact that regulatory arbitrage exists, which could be construed as a cat-mouse dynamic, is a manifestation of how private economic actors work to always circumvent current regulations.
Also, the fact that regulatory capture is stereotyped mostly in industries that are heavily regulated implies that many economic actors collude with regulators (or politicians) to "game" the system (example, monopolies, special licensing, private-public partnership and etc...).
Fourth, it is also true that with the growing sophistication of markets, diversified security instruments may be used for hedging, than simply a one-direction trade, often seen in underdeveloped markets. Hence, unless governments opts to bring society, as represented by the markets, back to the medieval ages, the question of conflicts of interest could be contentious and signify as controversial gray area.
Lastly, the ultimate lesson is nailed by Professor Kling, "you can blame the victims for failing to be wary or to protect themselves."
This means that without understanding the incentives driving the source of your information or those whom you do business with, you can increase your risks.
``Risk comes from not knowing what you're doing” warns Mr. Warren Buffett, we'd further improve "risk comes from not knowing the incentives with those whom you are dealing with"
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