Sunday, October 18, 2015

Escrow for the Common Good

Years ago, when I was teaching finance more regularly, I read The Squam Lake Report and thought its recommendation to improve corporate governance by requiring deferred compensation (in cash) for top management made sense. Why should a manager with significant oversight responsibility be paid in full today if the firm does not survive well into the future? It is a straightforward approach to moral hazard when the consequences of a manager's actions take some years to be fully realized. Put a portion of the payment in escrow, and hold it there until reasonable performance has been demonstrated.

I'd like to propose two other applications of the same basic idea to areas I have been thinking about for teaching and research of late. Consider the payments that are made by the public sector to organizations that operate prisons. Why should a prison be paid in full today to incarcerate an inmate who recidivates shortly after release? One estimate puts the rate of recidvism at 40% within 10 years. The prison operator has considerable control over the inmate's daily activities while incarcerated. That time should be used to help prepare the inmates to stay out of prison upon their release. If it is not used productively, it shouldn't be just the taxpayer who bears the financial cost to re-incarcerate the prisoner. Why not condition a portion of the payment to the prison operator on the released inmate staying out of the penal system for some period of time? Put the payments in escrow, and release them to the prison operator slowly over time, based on the released inmate's law-abiding behavior. The low cost of interventions like prisoner education and job training compared to the relatively high cost of re-incarceration suggests that prison operators have room to do a better job.

The other example is higher education. Policy makers are currently wrestling with the issue of what to do about student debt repayment. By some estimates, 1 in 6 borrowers are severely delinquent. Why should a university be paid tuition in full based on the proceeds of a loan that may not be repaid? The university has every opportunity to convey knowledge and teach skills that increase the likelihood of repayment. But it does not bear the financial consequences of a loan not being repaid. Instead, put a portion of the tuition payment in escrow, and release it only as the student loan is repaid. This arrangement provides a financial incentive for universities to provide a better education and to avoid enrolling students who are unlikely to be able to convert this education into enough earnings to repay their loans. These two issues are at the heart of our student debt repayment problem. The problem is financial -- the solution should also have a financial component.

1 comment:

john said...

These are nice linkages, like matching cash flows or duration matching a portfolio of risk. Similar should have been in place in the mortgage biz. In fact, an idea percolates up, that it may be these mismatched payments/benefits situations that invite the fraudsters, as news continually indicates in the areas you mention.

John