19 March 2010

The Simple Financial Reform Act

My plan for financial reform is simple.

Bankers get two kinds of bonuses: positive and negative.

Let me elaborate.

If a bank makes a billion dollars in profits, some banker in it might get a bonus of a million. This kind of thing actually seems like a pretty good deal for banks and their shareholders. If some guy can find you a billion in profit that you weren't going to have before, it only seems fair that you share the wealth. I honestly have no problem with institutions like banks sharing profits with people who take initiative. In this way, banks (or corporations) do what smart governments have done for business people for centuries: let these individuals keep a portion of the money they make. (And countries usually let entrepreneurs and individuals keep about 50% to 70% of what they make, whereas banks and corporations only let their employees keep about 1% to 20% of what they make. If anything, banks and such may give too little for a bonus.)

So business people within a country have an incentive to take risk. They start a business to make money. To get a return, they have to take a risk. One of the simplest rules of business and investing is this: higher risk yields higher return. But the business person is also careful about taking risk. Because the even simpler rule is that more risk means more risk. The business person could lose his business and his house. He's bold but not reckless.

The problem with bankers is that they, too, have an incentive to take risk. They make up new financial instruments, make investments, and try new things in seek of higher returns. If these risks work out, they get a big return. But if these risks don't work out, they get nothing.

It is easy to say that the bankers are greedy. But really, how would any of us play this game? The more risk you take, the more you can make. Oh, and if you lose the bet, you get nothing. That's right. You don't get a negative amount. You simply don't get a bonus. You would be right to take huge risks. But of course, even if you can't do worse than zero, the bank can lose billions or even trillions.

An easy way to continue to motivate bankers to move banks forward is to continue to give a bonus. An easy way to make sure that the risks they take moving forward are bold but not reckless is to mandate that their bonuses can be negative as well as positive. Sure you can make a million but you can also lose a million. Or, if you are playing options and the like, perhaps lose tens of millions.

This is not something that bankers will adopt themselves, any more than popes willingly gave up religious control over regions of Europe or kings willingly gave up control over portions of their kingdom. Nobody with huge power ever just voluntarily gives it up.

But as long as governments are insuring banks - as they should - they can stipulate how something like a bonus is calculated. And I suspect that no one regulation would do more to ensure a balance between the necessary risk taking to keep the industry innovative and the cautious risk avoidance that would keep the financial industry from regularly imploding.

1 comment:

Thomas said...

I think we should put the Mafia in charge. Success is very richly rewarded, but those who fail lose a thumb or sleep with the fishes. That's kind of the carrot/stick paradigm you're proposing.

As an added bonus: they have a very low default rate on their loans.