This is an educational post covering some of the flaws in our current financial system.
1. Banker Compensation
The banking compensation system has created incentives for excessive short-term risk taking. Executives are usually compensated with bonuses that are tied up to short-term profits. This puts a great incentive on executives to take larger risks in order to increase their paychecks. This unhealthy level of risk taking could be one of the reasons why many companies/banks are unprepared for the current downside in the markets.
2. Securitization Problem
The securitization model had been to “originate and distribute”. As a result, many debt originators did not care about the creditworthiness of their borrower. Only caring about the fee they were charging, originators put together any junk available and transferred the risk to someone else. Additionally, they repacked these junk securities into collateralized debt obligations (CDOs) or even CDOs of CDOs.
And if that wasn’t enough, the rating agencies gave these securities a nice AAA rating. Therefore, what you ended up getting was a bunch of junk (a.k.a “toxic” ) securities which are seen as a safe investment. This led to even more risk taking.
3. Lack of Transparency
In the past few years, financial markets have become less transparent in many different ways. The first problem is the development of new exotic financial instruments that are hard to value and price. Many of these instruments are not traded on an exchange which makes it hard to know who is holding these instruments ( meaning, we don’t know which firms are exposed to these very risky products) . On top of that, many of the institutions holding these very risky instruments have little or no regulation such as hedge funds. All this has contributed to a lack of transparency in the markets.
Stay tuned for Part 2 of the current flaws in our financial system.
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