The Ranting Kraut

19.3.2006 – 27.9.2010

Taming the Bankers

Posted by rantingkraut on September 27, 2008

The current financial crisis predictably has socialists gloating about the demise of capitalism and the blessings of state regulation. They will probably be wrong about the demise of capitalism –a prolonged crisis not withstanding– but may have half a point about regulation. The question is how exactly a leash should be designed if investment bankers are to be kept on it.
Most free market economists would agree that financial markets need prudential
regulation (regulation aimed at protecting the financial system as a whole). Plenty of this type of regulation is in place, but unfortunately this is not enough to prevent periodic crises from occurring. Equally unfortunately, nobody seems to know how to optimize prudential regulation to prevent crises in practice. When things go wrong badly enough there is then often no alternative to using tax payers’ money to rescue troubled financial institutions threatening to bring others down with them.
Institutional investors know this of course and therefore take risks they might thing twice about if they did not know that, in the worst of cases, tax payers will have to bail them out. The jargon word for this is moral hazard, although the tax payers footing the bill will surely think of more colourful expressions. Many normal earners probably don’t mind CEOs getting rich, so long as they justify their earnings by their results and face the consequences if they don’t deliver. But to watch those who have just sunk a major financial institution walk off with a fat bonus after a tax funded bail out is –to put it mildly– unlikely to endear the recipients of such largesse to the public.
A natural instinct may be to call for a tax on bankers or the rich. The problem with this approach is of course that the people so taxed, and probably part of the industry they work in, will migrate to a more welcoming location. In the long run, Boris is probably right that the finance industry is contributing to the nation’s wealth.
Lukily, God has given us bloggers and pub philosophers to solve the problems of the world. So, without further ado, here is my cunning plan:
1. Banks in many countries already have to deposit a proportion of their assets with the central bank. Let’s do the same with part of their top executives’ pay: let them deposit part of their pay (their bonuses say or a proportion of their salary) with the central bank for sufficient length of time (e.g. 5 years).
2. During this time let them decide how the money should be invested so that the equivalent of the investment return can be paid out at the end of the deposit period.
3. If the bank or financial institution in question needs to be rescued with public funds, then, and only then, the deposited earnings should be fully available to contribute to the cost of the rescue package.
The idea is of course to create a sufficiently high direct cost of financial mismanagement for the decision makers in charge of financial institutions. Moral hazard is a problem because the cost of failure can be offloaded to others (the tax payer). What is needed is a mechanism that brings at least part of that cost back to the people responsible for it.
The number of years mentioned for the deposit period under 1. is completely arbitrary but should be long enough to judge whether past management practice has resulted in an unsound financial condition of the financial institution in question. At the same time the build up of potential earnings should be sufficiently large for their potential loss to be taken seriously by the intended recipient.
2. Is designed so that the cost of this deposit is limited to deferred consumption during the deposit period if no tax funded rescue package is needed. Point 3. generates a personal financial penalty for creating conditions in which the financial institution needs to be rescued. The amount of the foregone bonus payments is unlikely to cover even a significant part of a publically funded rescue package, but it should hurt the banker, fund manager etc. enough for him to do his utmost to avoid it.
Part of the appeal of this argument is that there is no need to know precisely which aspect of investor behaviour should be regulated and in which manner. Instead, the logic of giving bonus payments is simply inverted:
Bonus payments give top mangers performance incentives by allocating to them part of the extra profits they generate. There is no need to know how exactly those profits are being generated, and the owner probably doesn’t know this. Since the bonus is conditional on success, the executive in receipt of the bonus is rewarded for doing what works in practice.
The potential loss of Bonus payments gives top mangers a risk avoidance incentive by imposing on them part of the systemic costs they generate. There is no need to know how exactly those costs are generated, and the regulator probably doesn’t know this. Since loss of the bonus is conditional on failure, the executive who is losing the bonus is punished for doing what did not work in practice.

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