The Reality Gap – Part 5 Finance Industry – Truth and Fiction

The United States’ finance industry has taken a real beating in the past three years. Since the beginning of a recent, severe recession starting in late 2008, no industry has been under more scrutiny than finance. Countless executives have lost their jobs. Huge banks have gone under. And, most importantly, average Americans have seen their wealth dwindle as the economy has slowed to a crawl. Millions have been left wondering what happened, and why. The answer, though it may seem complicated, comes down to a few basic economic principles. These principles reveal the truth about what we think we know, and what actually occurs in the finance industry.The first is a principle called “adverse selection”. According to economic theorists, the riskiest, most dangerous candidates in finance are also most likely to get a government backing, simply because they seek that backing with more effort. As an example, think of the FDIC. Currently, this government agency insures all depositors’ money in an FDIC backed bank up to $250,000. The Wall Street giants you most often hear about in the news are all FDIC backed. So, no matter what happens to the bank itself, its employees will have no one to answer to even if the bank goes under. You’ll never hear this fact in ads for big banks on CNBC or CNN. Since the recession started, the banks have put a large focus on “responsibility” in their advertising and public relations campaigns. They have been desperately trying to convince the American public that they can be trusted. But, by seeking and accepting the FDIC’s backing, these same banks demonstrate that they don’t trust in their own responsibility enough to go without a safety net.The other economic effect of the governmental safety net on the finance industry is what is known as “moral hazard”. This principle states that when an organization doesn’t have incentive to act responsibly, they are bound to take on more risk. This lack of incentive for responsibility doesn’t just come from the government, though. When the risky investments pan out for a big bank, its employees, investors, and even depositors are all happy. The higher the return on assets and equity, the more successful a bank is considered to be. This explains why, in the early years of the new millennium, the finance industry was so willing to give out risky home loans. They could charge higher interest rates, and in effect rake in higher profits. This, in combination with the government safety net discussed in the above paragraph, removed almost all incentives for financial institutions to act responsibly. As long as their balance sheets looked good, they were easily to convince investors and the public at large of a false reality.Government, of course, does realize that these problems exist, and has come at them head on. Today, banks are charted, they must hold certain percentages of excess reserves and capital, and their asset holdings are severely restricted. But when the object is as strong as money, the financial industry will continue to find ways to increase risk in the hopes of increasing reward. And though new public relations efforts widen the gap between financial images and truth, the game of cat and mouse continues.

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