Banking's Tragedy of the Commons

Bankers are neither stupid nor evil, despite what the popular press may suggest. Yet they continually engage in socially costly behavior. As a case in point, the race to the bottom in loan underwriting standards has begun once again — particularly in leveraged loans and real estate. Banks seem to have unlearned the harsh lessons of the financial crisis in just six years.

Apologists will argue that this time is different. But a number of bankers and regulators are concerned about declining credit standards. The problem is real — and it is also endemic to credit markets.

Although banks continue to recover from the crisis, they operate in a difficult environment. They must assume more asset risk in order to increase loan volume and yield, thereby improving returns on equity.

Bankers, it seems, cannot help themselves when it comes to controlling their risk appetite. Once competitors loosen risk standards to gain market share, other institutions are forced to match the action to maintain their position. Former Citigroup chief executive Charles Prince put it best when he said that as long the bull market music is playing, you have to keep on dancing.

No one banker can unilaterally withdraw from a lending activity by adhering to conservative standards and still retain his job. Sitting out the dance is not an option under these circumstances.

This situation is banking's version of the tragedy of the commons, whereby each individual makes the decision that is best for himself or herself although it is to the detriment of the larger population. Individual banks have an incentive to lower credit standards, as they can initially capture the full benefits of their actions. They have no incentive, however, to be prudent. This is because of the free rider problem: those who lower their standards can share in the industry-wide benefits created by prudent bankers without incurring their costs.

What is a smart decision for one person ends up being a dumb choice for all. Imprudence becomes the market standard, as Alan Greenspan was forced to admit. Self-interested individual actions can lead to collective failure instead of the invisible hand's enhanced social welfare. Financial markets, while efficient, are imperfect.

A solution to the tragedy of the commons problem would be for banks to develop common industry credit criteria. However, such arrangements are highly unstable, since the incentive to cheat is high. In addition, the Justice Department would be likely to frown upon collusion among banks — regardless of the benefits — since the collective action would be viewed as collusion under the antitrust laws.

Alternatively, the government could impose lending safety standards to prevent banks from hurting themselves. Banks would probably resist such efforts, however, arguing that additional restrictions would interfere with their ability to earn a profit. The industry's negative response to regulatory concerns over leveraged loans highlights the likelihood of this reaction.

The most likely outcome is another banking crisis. The tragedy of the commons underlies the credit market's boom and bust cycles. It is structural and has nothing to do with banking morals and culture.

Crises are the cost that we incur for having messy, free-market creative destruction. Attempted cures may be worse than the disease, because they wind up inhibiting innovation. Therefore regulators' focus should be on damage control, as opposed to crisis prevention. Banks should be small enough and sufficiently well-capitalized to ensure that they do not endanger the real economy when trouble occurs. Absent that, we are left with politically unpopular government rescues.

I have seen the tragedy of the commons in banking many times, both as a loan originator and as a risk manager. It always ends the same way. The lesson for bankers is clear: from a career standpoint, it is better to be aggressive and wrong in the long term than prudent but early in the short term. As long as the music is playing, keep dancing. Regulators should develop firewalls to limit the damage when the music inevitably stops.

J.V. Rizzi is a banking industry consultant and investor. He is also an instructor at DePaul University Chicago.