Wednesday, February 4, 2009

Game Theory: Why Giving the "Option" to Limit Pay Won't Work

The AP reports:

The Obama administration plans to limit pay to $500,000 a year for executives of government-assisted financial institutions in a new get-tough approach to bankers and Wall Street, a senior administration official said Tuesday.
Back in September I used the below chart to show why giving banks the option to accepting TARP money with the caveat that they must limit pay will fail (they key is the option). My guess... if this passes, many banks will simply give the bailout money back (hey, maybe that's what the Whitehouse is hoping for).

Originally posted September 26th, 2008:

Lets assume for the time being that there are only two banks; Bank A and Bank B.

The media / political pundits would have you believe the likely outcome of the bailout is the top-left box in which both Bank A and B sell risk assets to the Treasury. In this case, the result is a more regulated banking industry, with imposed limits to salary, but importantly markets clear.

Click for larger table:

HOWEVER, it is in BOTH banks interest to deviate from that.

Why? Simple. If Bank A (or B) believe the other is selling their risk assets to the Treasury; they will each be better off holding on to theirs.

Why? If the other bank sells and they hold, markets will still clear (in theory) and the bank that holds onto their risk assets can sell at the new market prices. This results in increased market share as they:
  • Can pay more for talent
  • Are less regulated
  • Don’t have the stigma of selling to the Treasury (think of what selling portrays to the market)
This is even worse in the “real world” as all banks have the incentive to wait for other banks to sell risk assets to the Treasury to clear markets.

The likely result? The bottom right box in which no bank sells voluntarily and markets remain frozen. While there were many problems with the initial plan, at least there was a 100% incentive to sell the assets.