Give Wall Street traders skin in the game
Losses should hit their personal wallets
The financial crisis of 2008-09 is over but not gone. We passed regulations that probably won’t help much. And despite a lot of harsh words aimed at Wall Street and the banks, the Obama administration pretty much let individual bankers escape unscathed.
But relying on regulators to control banks and Wall Street is likely to fail anyway. Leaving aside their political influence, financial types are likely to stay ahead of regulators because 1) they’re usually smarter; and 2) they understand their industry better. Plus, they can change approaches faster than regulators can amend regulations.
The change in the financial community over the past few decades has been dramatic. The economic crisis brought the activities of investment bankers into the limelight, and suddenly it seemed the staid buttoned-up banker types of the popular imagination had been transformed into wild speculators risking billions on a single trade. What happened?
According to Claire Hill and Richard Painter in their new book, Better Bankers, Better
Banks, the reason is that the billions they’re risking on a single trade aren’t their own but somebody else’s.
Until fairly recently, big investment banks such as Goldman Sachs or Salomon Bros. operated as general partnerships. In a general partnership, the partners are liable — individually — for debts of the firm. With potentially unlimited liability if things went wrong, the partners had an incentive to be comparatively cautious. As Hill and Painter note, Salomon’s culture changed very rapidly after it became a corporate entity in which the partners, now called “managing directors,” weren’t personally at risk. Within a few years it went from a staid, conservative business to the anything-goes entity described in Michael Lewis’ Liar’s Poker.
Hill and Painter’s solution is something they call “covenant banking,” in which bankers’ compensation is at risk for bad deals. Not only would they get bonuses when things go well, they’d also have to cough up past bonuses, and salary, when deals go badly for clients. Banks might want to do it voluntarily. As a client, wouldn’t you rather deal with a banker who stands to lose money if you do? Shareholders might even demand that their companies do business with such banks, as a way of hedging against risk.
I’m not enough of an expert on banking and finance to say whether Hill and Painter have it right with covenant banking. But I do think that — across many sectors of our society — our problems come from having people in charge who don’t feel the pain when their various schemes go bad. As a theme for the coming decade, we could do a lot worse than requiring skin in the game. And, sad to say, we probably will.