How to Prevent Another Financial Crisis? Make Wall Street Pay

Closed bank: How to prevent the next financial crisis
Closed bank: How to prevent the next financial crisis

Given the huge costs of the current financial crisis, it's important to prevent future ones. But Washington's latest proposals to do that don't really get at the root of the problem that caused this one. That's because they don't change how bankers get paid in ways that align Wall Street's interests with those of its customers. So, lawmakers' current plans assure that the best and brightest people will continue to go to Wall Street and that regulators will continue to play catch up.

I would propose an approach that shifts incentives so that bankers can effectively regulate themselves. Specifically, bankers would get paid based on a share of their customers' long-term investment returns, and they wouldn't get bonuses if their banks violated capital requirements. I would also remove the temptation for bankers to write their own report cards by transferring all financial reporting responsibility to a government agency.

An Incomplete Start

Let's look at what Washington is now proposing. According to an analysis in the Sunday New York Times Magazine, the current thinking about how to prevent another financial crisis centers on four focal points:

  • Requiring financial institutions (FIs) to maintain more capital.

  • Creating a government agency to protect consumers from FIs' predatory products.

  • Giving government power to unwind FIs that have been deemed too big to fail (TBTF).

  • Taxing FIs to cover the costs of bailing them out.

I have a mixed reaction to these proposals. I like the idea of making FIs hold more capital. But I doubt it will be possible to get them to keep enough to make a difference. That's because capital requirements always loosen when an economic recovery gets going. And the current proposal doesn't specify the level of capital banks would need to maintain, nor does it establish how to monitor compliance with whatever standards might emerge.

The idea of taxing Wall Street more is also good, but it faces some tricky problems. If banks pay the tax before a crisis that leads to a bailout, the prepayment may tempt them to take bigger risks because they know the government will ultimately bail them out. If government levies a tax on banks after a bailout, there may not be enough solvent banks around after the crisis to pay the taxes.

The other two ideas seem like half measures. The consumer protection agency seems harmless in theory, but it suffers from two problems. First, consumers should take the time to understand the benefits and risks of the financial products they're considering rather than relying on the government to keep them out of trouble. Second, unless the proposed agency employs smarter people than the banks do, the banks will generally outmaneuver the consumer agency. Finally, as I've written, I think banks that are TBTF should be broken up.

Conflicting Interests

If Wall Street has the right incentives, it will be more careful in considering risk to its shareholders and customers. But in the buildup to the current financial crisis, participants in the network of creating mortgage-backed securities (MBS) got paid in ways that were instead at oddswith customers' best interests.

Here are two examples:

  • Yield spread premium. Brokers that sold mortgages to consumers got a bigger commission (typically $2,000 more), known as a yield spread premium, if the brokers convinced borrowers to take on a more expensive subprime mortgage even when the customer could have qualified for a cheaper, prime mortgage.

  • Rate shopping. As I posted in 2007, investment banks that created mortgage-backed securities encouraged ratings agencies to compete for fees totaling in the billions to provide AAA ratings on bundles of mortgages that later turned out not to warrant such stellar ratings.

We ought to change the rules so that Wall Street bankers get paid only out of the five- or 10-year investment returns to the people who buy those investments. This will focus Wall Street's mind on taking risk into account when it invents and sells products.

We might also take away money from bankers if they violate capital standards. We could set standards for bank safety, such as a maximum ratio of debt to equity of 10:1 (before the financial crisis those ratios went as high as 30:1). As a colleague has suggested, "If the institution violated these ratios, the executives would lose all of their stock options and accrued bonuses."

Fear of losing bonuses would force bankers to regulate themselves. He continued: "Given such a potential big hit to their wallets, you could almost leave them free to do whatever they wanted to do. They're not dumb, and they would operate within the constraints that are set. This would reduce the costs of regulation because it would focus on the doers themselves rather than trying to regulate the products they come up with."

An Alignment of Incentives

This will only work if an independent government agency produces report cards, instead of letting Wall Street write its own. This agency would report on whether banks are complying with capital standards (of course, given how Lehman Brothers evaded those standards through Repo 105, this will be a challenge). And it would produce reports on how those customer investments are doing (taking that power away from the Madoffs of the world).

The result of these measures is that Wall Street would have every incentive it needs to comply with capital rules and sell investments that it believes will generate long-term profits for its customers. This would probably lead FIs to take less risk and occupy a smaller role in the global economy. But we might all be better off if more of the world's top talent worked on technological innovation rather than on creating ever-more-complex financial instruments.

Only when Wall Street's interests are aligned with its customers' can we be sure that customers won't be turned into victims. And Wall Street must understand that it will have to pay to resolve the next financial crisis. Because if Wall Street has to pay, it will make sure we never have another one.