What is to be done with the bankers? From the savings and loan meltdown in the 1980s to the current housing-led seizure, financial institutions have proved unable to curb their appetite for risky assets -- blowing up the bank and spreading economic mayhem.
After every crisis, regulators say they will cure the financial system of the recent folly, reassuring the public that the caustic asset du jour -- Latin American debt, Internet stocks, mortgages in Florida -- would never again be allowed to bring the banks down.
Yet the recurrence of disasters suggests that the risky cravings of the masters of the universe are uncurbed. All that happens is that the next crisis takes a somewhat different form from the last, using some newly noxious financial product that used to be considered safe as, um, houses.
It's not just that a rogue junior trader at a French bank can single-handedly chalk up losses of more than US$7 billion without anybody noticing. The subprime strategies that last year wiped out about US$22 billion at Merrill Lynch, US$20 billion at Citigroup and US$9 billion at Morgan Stanley were devised and encouraged at the very top.
There's nothing like a smart banker motivated by an otherworldly bonus to get around the most carefully written regulatory limits on his or her ability to make money. Say regulators demand that banks maintain a big cushion of capital as a share of their loans, as a form of insurance in case the bets go bad. All a wily banker has to do is move the risky investment to a "structured investment vehicle" and claim it is not on the balance sheet. And there are other tricks.
Bankers' recklessness would merely be a problem for shareholders to solve if all that banks lost was shareholders' money. But banks, as we painfully relearn every few years, spread the damage widely.
Regulation certainly needs tightening to mitigate the worst kind of irresponsible, often predatory lending that led to our current mess. But there is a part of the problem that regulators do not touch: Bankers have an incentive to bet the bank every time around. That's because of how they are paid.
In a good year, top bankers' pay would shame Croesus. But they don't have to return past bonuses when the year is bad. Merrill fired its chief, Stanley O'Neal, and Citigroup dispensed with Charles Prince. But Morgan Stanley's John Mack is hanging on. None of them have returned the untold millions they made in all those years when their banks were stuffing themselves with subprime loans.
A better alignment of rewards with the long-term performance of the bank and its investments could reduce the incentive to maximize profit in the short run and shrug off the possibility that the bet sours just around the corner.
One approach would be to pay a large share of all bankers' remuneration with restricted stock that vested over several years. To impose discipline on individual bankers, Raghuram Rajan, the former chief economist at the IMF, suggests that banks should hold a big chunk of bankers' pay in escrow to be paid out over a long period. Compensation could then be made contingent on the long-term success of each banker's strategies.
Bankers who had to forfeit substantial portions of their pay if their investments turned bad down the road might discipline their craving for things like subprime mortgage-laced collateralized debt obligations.
Remuneration is tricky terrain. Banks might resist reconfiguring bankers' pay out of fear that their top talent would jump ship. But regulators could encourage bankers to voluntarily rejigger their compensation schemes. Just as changes in the tax code in the 1990s prompted a surge in equity-based pay, other changes might encourage bankers to think about the long-term consequences of their actions.
If banks do not want to address the problem, they risk congressional action. For many members of Congress, regulating bankers' livelihoods to keep them from ruining everybody else's may seem like an attractive move.
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