The financial reform legislation will address specific business activities that led to a massive run on the largest financial institutions in 2008. Understandably, it looks backwards to analyze what went wrong and regulate those activities.
It would be naïve to think that this is a complete, long term solution to the problem of periodic, systemic financial crises. Historically, bank panics tend to run in more frequent cycles unless the underlying causes of those panics have been addressed. More is needed to root out the causes.
The power inherent in the financial sector as the arbiter of capital flows in our economy is formidable. Society allows the bankers to amass wealth as they wield this power because it is in the long term interest of us all. The unwritten contract demands that the financial system provide capital to generate sustainable jobs and investment opportunities for the public.
The major Wall Street banks breached this contract. As I have previously written, massive changes in the sector fostered by technological advances and deregulation allowed this to happen. Deregulation conveyed the impression that the contract no longer mattered; technology allowed the banks to deploy their huge advantages in capital and information on a massive scale at the speed of the processor. The rise of the traders to control Wall Street shifted the focus from clients to transactional relationships. The social contract got lost in the shuffle. Re-alignment of incentives of bankers with the long term interests of the economy is the only way for the public to demand performance.
Implications of this tectonic shift are massive. With all of our large institutions dominated by trading, the risk of illiquidity remains extreme. Firms dominated by trading fail because they run out of cash, not because liabilities exceed assets. The crisis is abrupt, and the value of other, stable businesses cannot be used to stave off failure. Trading risks are inter-related among the trading banks. While this is mitigated by clearing, the business is so concentrated in the largest financial institutions that the conditions for a general meltdown persist.
Traders are very much individual entrepreneurs. They are allocated capital and trade their books within the constraints of rules imposed by their employer. At their core, they believe that they are responsible for the revenues which they generate and are compensated on this basis. Generally, this is an effective way for the financial institution to achieve maximum profit from a trader. The message to the trader is to make as much money for the firm as possible as quickly as possible. Trader success is very personal and perspective is defined by the cycle of bonus pool allocations.
While the legislation is important, we must address the motives behind dangerous behavior by Wall Street. The traders will not simply accept the new regulations passively. These are some of the most competitive and resourceful people on the planet. They will adapt so that they continue to earn huge bonuses by doing what they do best. Inevitably, they are at work crafting the next opportunities. It is impossible to predict what will precipitate the next meltdown. The dysfunctional relationship between the short term view of the financial sector and the long term needs of the American public assures that the cycle of runs on the financial system will continue.
Appeals for altruistic behavior are worthless. Traders genuinely believe that the public's interest is served by the efficiency of self-interested market activity. There is truth in this viewpoint, but it ignores larger issues which traders cannot easily internalize and still perform their jobs effectively. It is time to address the core of the problem
This is compensation. We are painfully aware of the housing bubble. But there is an ongoing compensation bubble embedded in our financial system which distorts the relationship of the sector to the economy as a whole. A system which excessively rewards short term perspectives and trading techniques which do not build an economy geared to generate wealth broadly is not sustainable.
This is deeper than compensation of the heads of banks and hedge funds. The compensation of individual traders is more pervasive. A direct relationship between compensation and trading techniques defines their roles and encourages their behavior.
Banks argue that they must pay vast sums of money to retain traders and prevent them from moving to hedge funds. I, for one, believe that this is overstated. Nevertheless, the compensation issue applies to hedge funds and other non-bank financial organizations as well - it is the incentive-based behavior which is the problem.
There have been proposals to tax bonuses. This seems to have a greater appeal in Europe than here. It may be more practical to curb compensation by targeting employers. Limiting the ability of any institution involved in securities trading to deduct compensation above a specified level would discourage excesses. So would an excise tax on excessive compensation by the employer. Whether a tax or a limitation on deductibility is the method, setting the level at which it kicks in has both practical and political implications. A multiple of median household income would be a good start. It has the benefit of being tied to the general welfare of the public.
New York politicians would likely resist this as an unfair penalty that affects state and local tax revenue. Corporate profitability is, however, the principal engine of tax revenue. The politicians should also be aware that basing fiscal integrity on a bubble (here the compensation bubble) is unwise.
Finally, there is an argument of sorts that has been made by opponents of compensation reform that must be addressed, even though it is probably a cynical effort to deflect discussion from the main point. The argument is that the public tolerates high levels of compensation of athletes and entertainers so why punish bankers? One word comes to mind: Wow! It is the behavior of bankers which is the concern, not retribution to assuage abstract moral indignation. There is no history of a baseball player behaving in a way that risks another Great Depression. The goal is to assure that financial sector incentives are more aligned with the interests of the people. Personally, I am not so concerned with alignment of interests with sports and entertainment. I still prefer an afternoon at the ballpark over a day at my computer writing about trader excesses that threatened the republic.
Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.