Getting Personal With Financial Institutions
Brad DeLong considers various issues in using financial regulation to improve incentives and ends up offering this observation:
Managers and traders are, however, where I would focus most of my attention. I believe we need compensation reform: compensation schemes that make it a complete personal catastrophe for the CEO and all other employees if their bank fails. If managers and traders are, personally, wiped out–reduced in assets to their last two cars and their last four-bedroom house–if any financial institution they worked for goes bankrupt anytime in the next two years, then we have a chance of creating sufficient caution. Otherwise, I don’t see how we do it.
This seems to me like something that would be pretty feasible to implement. You could create special liability rules for the employees of what will in the future be classified as Tier-One Financial Holding Companies establishing something along the lines of what DeLong suggests. In the event that the government needs to intervene with a bailout, everyone will have their personal assets above $X wiped out as recompense. This would both create an incentive for Tier-One Financial Holding Companies to be cautious and also create an incentive for managers to consider whether they don’t want to downside (or streamline or simplify or whatever it may take) their operation so as to avoid attaining that lofty regulatory status.
35 Responses to “Getting Personal With Financial Institutions”
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June 24th, 2009 at 4:05 pm
If you want to ban financial institutions above a certain size, the you should advocate that. This proposal would do so in a round about way (nobody in their right mind would work at such a company as long as they had other options).
June 24th, 2009 at 4:07 pm
I’d go for it, if we include Congress and pundits in the same scheme. Otherwise it’s back in the USSR, and being shot for missing quotas.
June 24th, 2009 at 4:09 pm
Bribes and punishment are two sides of the same coin. They work against producing quality products, even financial ones. Improving quality requires minimizing extrinsic motivators.
The solution you propose will make matters worse, much like the President’s plans for education and health care reform. Pay for performance in those arenas will do great harm over time.
To get people focused on quality, pay them fairly and focus their mind/attention/heart on the work, not on some intricate reward/punishment pay scheme.
“Will they ever learn?”–Dr. W. Edwards Deming
June 24th, 2009 at 4:13 pm
Yeah good luck with that. Maybe in a dream world something like that would be possible, but not in DC.
Although seeing the Senate debate such a bill would be entertaining.
June 24th, 2009 at 4:15 pm
You just described employee retirement accounts at Enron and WorldCom. That didn’t prevent the next round of implosions.
One failure of a theory requires its modification.
June 24th, 2009 at 4:15 pm
That’s pretty absurd. I’m a trader with a non-tier 1 type company. We’re small, I am on a first name basis with our CEO and the major investors, but I’m still not in any position to manage the risks of my fellow traders or gauge the financial stability of my firm. At a huge place, with several different divisions that by regulatory statute cannot know what the other divisions are doing, this would be impossible.
If I manage those who sell life insurance at AIG, why should I have my wealth confiscated because of some other division’s trading losses? Who would take such a job except someone with no wealth to lose?
Honestly. The ignorance of my fellow liberals on this issue is staggering.
June 24th, 2009 at 4:21 pm
If I manage those who sell life insurance at AIG, why should I have my wealth confiscated because of some other division’s trading losses? Who would take such a job except someone with no wealth to lose?
Matt wrote “$X”. X could be 10 million; it could be 100 million. That should protect the intern or the young trader, or pretty much anybody except the top earners.
But as I said, no compensation reform will ever pass. Politicians would rather give free health care to illegal immigrants or even help unions (the people they hate most in the world) before they take on Big Everything.
June 24th, 2009 at 4:23 pm
Alan wrote: To get people focused on quality, pay them fairly and focus their mind/attention/heart on the work, not on some intricate reward/punishment pay scheme.
This is just as applicable to the current pay systems in many of these companies. The employees have very intricate pay incentives, and focus on getting the numbers that maximize their bonuses, regardless of the long-term results for the company. It’s really a failure of the management system that developed the compensation packages – but since the management themselves are major beneficiaries of the system, it’s unlikely that they’ll change it on their own initiative.
June 24th, 2009 at 4:25 pm
Why not just require them to be partnerships, and not publicly traded corporations?
You will notice that you can’t get an audit done by Arthur Andersen any more…
June 24th, 2009 at 4:34 pm
This is completely insane and Brad DeLong is a moron.
Wipe out every trader personally if the institution they’re employed by, with potentially tens or hundreds of thousands of employees, fails? By reason of their action, reasons that they were a minor contributor to, or reasons that they had nothing to do with?
There is a reason we have things like bankruptcy law and don’t just throw people into debtor’s prison any more. Spend a few minutes thinking about why and you’ll understand why this post is the dumbest thing I’ve read all day.
June 24th, 2009 at 4:37 pm
Managers and traders are, however, where I would focus most of my attention. I believe we need compensation reform: compensation schemes that make it a complete personal catastrophe for the CEO and all other employees if their bank fails. If managers and traders are, personally, wiped out–reduced in assets to their last two cars and their last four-bedroom house–if any financial institution they worked for goes bankrupt anytime in the next two years, then we have a chance of creating sufficient caution. Otherwise, I don’t see how we do it.
Well, in a way this actually used to be the case with the big Wall Street firms back when they were partnerships. The partners were relatively cautious, because they knew that the bulk of their wealth was tied up in the equity of their firm, so if it went down so did they (as is still the case with most law firms today). But in the 90s as the going public mania overtook them and they all issued shares to the public, the managers were no longer the owners, and so the alignment of interest no longer applied.
June 24th, 2009 at 4:40 pm
A key distinction gets glossed over.
Commercial banks create money out of thin air by virtue of their connection to the Fed and their reserve requirements. If the reserve requirement for financial firms other than commercial banks was 100% (they could only lend money they actually possessed), then the incentive to gamble would be much different.
And if commercial banks had high barriers for lending for speculation, another gap would be closed.
Glass-Steagal should be reinstituted to clearly separate commercial banks from other financial firms. Commercial banks should then be treated like utilities. Private companies could do whatever with their money – but it should only be their money. The investment banks were much more cautious when they were partnerships.
June 24th, 2009 at 4:45 pm
The problem here is that the public doesn’t understand how financial institutions work or how they make money.
Risk means profit. You cannot make money without taking on risk.
Pay structures already align employees’ incentives with making their firm money. Any discussion of short-term vs. long-term is moot… trading is by definition a short-term business. A trade made today may make money this week and lose money next week – the idea is to exit the position before it starts losing money. Traders that made bets that made money for a while and lost money later weren’t responding to distorted incentives in their pay structure, they were attempting to make the bank money.
With regard to one of the biggest villains of the crisis, the mortgage-backed security, it’s not that people were trying to maximize their current year pay, and consequences be damned when the housing downturn and rise in defaults blow a hole in the bank’s balance sheet a couple years later. They just didn’t think the latter event was going to happen.
Let me say this as simply as possible: financial firms make money by taking on risk. Sometimes that risk leads to extraordinary profits; sometimes it leads to extraordinary losses. This is the business of finance.
Now, if you want to restrict just how much risk they’re allowed to take on, through capital requirements, leverage limits, etc., then that’s a different conversation. And a logical one, given the implied government (taxpayer) guarantee of the big banks. The analogy, I suppose, would be mandating that people invest half their portfolio in bonds rather than putting 100% of it in stock, to limit their risk of catastrophic losses, which would make sense if the taxpayer was going to be on the hook for said losses.
But these logical steps have absolutely zero to with compensation levels or even compensation structures. The whole compensation issue is a red herring favored by politicians and the media because Joe Sixpack loves hearing that not only were those folks that make more money than him are to blame, but that money is the very cause of the crisis. The fact that neither of these things are true (the first not entirely true, the second not at all) is of course of no consequence.
June 24th, 2009 at 4:50 pm
Ron, if the reserve requirement was 100% banks could not loan money at all. They would need to keep 100% of deposits on hand, i.e. in reserve.
Traders don’t have enough control or influence to be punished in this way. C-level employees, however, do. Don’t take all their money, just all the money they were paid by the company that fails. 5-10 people losing the millions of dollars they were compensated while they were directly contributing to the failure of a given company would create strong incentives for caution and not harm the greater economy if it was ever invoked.
June 24th, 2009 at 4:53 pm
Shorter TH: finance is very complicated and American people are stupid. Let them eat cake.
June 24th, 2009 at 5:00 pm
hetherjw-
If I understand correctly, a 10% reserve reqt means a bank has to have $10 in reserve for every $100 it lends. A 100% reqt would mean the bank would have $100 for every $100 lent.
Commercial banks would still have the current 8% reqt or whatever it is today.
June 24th, 2009 at 5:02 pm
Or create an incentive to hid assets!
June 24th, 2009 at 5:10 pm
Amen. Does MY understand this? That commercial banks are unique in that regard. That they are more like a utility — certainly not a hedge fund or investment bank?
I am struggling to find the right analogy here, but can’t. We don’t have the guts to stop our-deposit-holding banks from making risky investments, oveleveraging, or becoming so “interconnected” that they are bound to fail — and take us with them. But somehow we’re going to “regulate compensation?”
This is pure idiocy.
Amen again.
This notion that we can’t turn back the clock by returning to Glass-Steagle is a lie. We could do it overnight. This notion that everything is so “interconnected that we can’t do anything about it is ridiculous. Deposit-holding, money-creating institutions are NOT private businesses.
June 24th, 2009 at 5:14 pm
So whats to stop the CEO leaving the company before it needs bailed out. How do you assign responsibility between current and previous CEOs?
June 24th, 2009 at 5:31 pm
TH @10: Spend a few minutes thinking about why and you’ll understand why this post is the dumbest thing I’ve read all day.
It’s possible, of course, that this post is the only thing TH has read all day. That took me less than five seconds to think of — imagine what a few minutes could yield!
June 24th, 2009 at 5:50 pm
Yes, it is a good idea. Take it from a lawyer, however, that these rules would not be enforced today even if they were on the books because our judiciary is composed mostly of Republican appointees on one hand, and pro-business social liberals appointed by Bill Clinton on the other.
Obama’s appointment of Sotomayor indicates that he is following Clinton’s lead in appointing pro-business judges.
Just passing a law that imposes liability is great in theory, but no private party will bother to try to enforce the liability if they are either facing a federalist society Republican appointee or a Sotomayor-style Democrat.
June 24th, 2009 at 6:09 pm
The US is being kept afloat by foreign central banks that are not interested in American traders and managers being threatened with the punishment of living a mere middle class existence. They want, and get, guarantees and assurances from the top – the Treasury, the Fed, and Obama – that their investments in the US are safe. Without said explicit guarantees, repeated over and over given the current situation, the Chinese would not invest one cent in the American financial system.
Even with such assurances, the capital outflows from the US are accelerating at such a pace that many fear that the country will go bust. Scaring, threatening, and punishing traders will not render AIG, Freddie, Fannie, the US banking system, indeed, the US, solvent.
June 24th, 2009 at 6:12 pm
Delong’s suggestion: Great!
Yglesias’s implentation: Idiotic!
Talk about perverse incentives!
1. Under Y’s plan, the more personal wealth that I have, the less likely I am to work for an LLC. Because I’ll have more to lose if the company goes under.
2. Stockholders would still have LLC protections, meaning the most they lose is their investment, but employees would still be on the hook for the corporation’s debts. Thus we create an incentive for stockholders to force employees to take risks against employee interests.
4. Meanwhile employees have an incentive to take no risks. The whole point of an LLC is to encourage healthy risk-taking.
5. This is terribly regressive. Under this plan, the Janitor would get wiped out if a company went under, but Warren Buffet would get to keep his wealth.
6. Lets not ignore the fact that confiscation of wealth already earned is almost certainly unconstitutional.
7. The name Limited Liability Corporation would become comically ironic, insofar as an LLC would maximize employee liability.
I’m certain that what D was suggesting, was nothing like Y’s suggestion. D was probably imagining something like managerial stock options that vest slowly at first, but only fully vest after a long time horizon, perhaps 5 or 10 years. This way long term planning has the strongest effect on managerial incentives and it also compensates for temporal discounting.
Seriously Y, think before you speak.
June 24th, 2009 at 6:17 pm
This is an incredibly disappointing idea coming from both MY and Delong. Sure there are major problems with the incentive structure in the financial industry. But this is madness.
June 24th, 2009 at 6:27 pm
Obviously, a dodge. Let’s directly attack the speculative economy by attacking the stock market. Any rule that would keep the price to earning ratio of stocks in the range of the real worth of the company would wipe out the whole incentive for making free vampire money. Buying stock would become, then, actually buying into a company. Roosevelt – Teddy – should have implemented this when he had a chance. It would actually make capitalism live up to that laughable slogan, efficienly allocating capital, rather than to the reality of chasing the highest yield. The highest yield would be the better product or service, un point c’est tout.
Don’t pussyfoot around. The speculative sector of the economy is the driver of all capitalism’s worst habits.
June 24th, 2009 at 7:45 pm
” 5-10 people losing the millions of dollars they were compensated while they were directly contributing to the failure of a given company would create strong incentives for caution and not harm the greater economy if it was ever invoked.”
To an earlier post, this would have gone a long way to keeping Enron and WorldCom from imploding as they did. Of course, the threat would have to be real and believable.
June 24th, 2009 at 8:26 pm
It would make far more sense to end the preferential tax treatment of capital gains income over wages. Privileging capital gains income with less than half the marginal rate of wages just creates the incentive to sink money into (hopefully) appreciating securities. And the act of sinking too much cash after too few securities both creates the incentive to concoct new securities, and causes the price inflation investors were hoping for.
Bubbles are not as unpredictable as bankers want to pretend.
June 24th, 2009 at 10:15 pm
@Aatos:
To be fair, bubbles predated the tax preference of capital gains. They seem intrinsic to economies.
June 25th, 2009 at 6:06 am
Delong has a proposal to make people responsible for their actions?
Is this the same DeLong that previously defended Yoo’s right to a life long, taxpayer funded position as a fellow tenured faculty member of his, because Yoo, a man instrumental in the laying of the foundation for the torture regime implemented by the American government, should not lose tenure, so as to protect the spirit of free inquiry which tenure shields?
Hypocrite.
June 25th, 2009 at 7:19 am
TH is right … there is no profit without risk in the financial biz.
The real reason why we are in such a mess is not because the stock market is down per se but because we depend (for our retirement, our extra spending money) on an inherently risky endeavor.
It’s the downside of Bush’s “ownership society”.
Of course, the speculators don’t help things (driving the price of oil up), and real estate prices are so high that even after the deflation of the bubble, my family still can’t afford to purchase the house my parents purchased when they were my age. And the increased disparity in wealth hasn’t helped much either (thanks Reagan’s 1980s!)
But fundamentally what has gone wrong is the fear (”the only thing we have to fear is fear itself”) of a collapse of the safety net when we need it the most driving people to dump ridiculous amounts of money into “the markets” inflating one bubble after another with disastrous results when the bubbles inevitably deflate.
Social Security is thus called for good reason. Paranoia about “I won’t have enough money to retire but will be sick from old age and eating dog food” has killed our economy. Paranoia induced by those with particular political (”drown the government”) and economic (brokers’ fees) agendas. If we want to have a truly capitalist society with flexible labor and capital available from markets, we can’t be in a position of depending on risky endevours, but rather we need a robust safety net.
The New Deal might not have gotten us out of the doldrums left in the wake of the Great Depression (Keynesian spending, in the guise of WWII did), but it has served as a bullwork against future “economic cycles” that used to be the “natural” course of the economy resulting in a disaster every 20 years or more frequently. However, the GOP (and DINOs and the so-called liberal media) convinced us the New Deal was outdated and that we should cheer their dismantling of it.
And what happened? Well …
June 25th, 2009 at 7:23 am
roger, I’m not so sure about your plan either …
In the 1980s, pension fund managers (there again, people “saving” for retirement distorting the market) actually made sure demand was linked to earings. What happened? Well, companies laid off people left and right to get their profits as high as possible so people would buy their stock. Of course, with no workers, no work could be done, so the companies imploded. And with fewer wage earners, the economy contracted.
But since the rich got richer, on “average” we were all doing better … umm …. weren’t we?
June 25th, 2009 at 9:06 am
Note that a sort of similar rule exists for not paying payroll tax – the company officers get held personally liable
for the amounts not paid. Seems to have a strong effect
in a positive direction.
June 25th, 2009 at 10:53 am
Matt,
This proposal is completely antithetical to the concept of limited liability corporations. It may be a good idea to abolish limited liability, but if so it should be done for all control-holding stakeholders (i.e. the stockholders), not just the employees.
Patrick C started off well by pointing this out, but then ran off the rails by speculating that Dr. De Long meant something (we should force long time horizons on incentive pay, which is certainly true) which Dr. De Long clearly did not say. He may agree that it’s a good idea; in fact he probably does. But what he said is exactly what Matt is asserting:
“I believe we need compensation reform: compensation schemes that make it a complete personal catastrophe for the CEO and all other employees if their bank fails. If managers and traders are, personally, wiped out–reduced in assets to their last two cars and their last four-bedroom house–if any financial institution they worked for goes bankrupt anytime in the next two years, then we have a chance of creating sufficient caution”.
What could be clearer than that statement that he proposes to remove limited liability from all decision-making employees? That would not likely include the janitors who were outsourced fifteen years ago. And it seems that he would not include the secretaries since he specifies “managers and traders” but it’s also true he says “the CEO and all other employees” in the previous sentence.
Since Dr. De Long himself runs off the rails regularly with his rhetoric, we can’t be certain exactly what span of responsibility he’s advocating. But we can be certain he is advocating stripping limited liability from at least some non-directorial employees.
Craig said “So whats to stop the CEO leaving the company before it needs bailed out?” That’s the reason for the two year look-back period in Dr. De Long’s proposal: “goes bankrupt in the next two years”. It’s a pretty arbitrary time period, obviously.
June 25th, 2009 at 10:58 am
Why oh why @7
You still didn’t answer my question. Investment banks and other financial institutions have divisions that have nothing to do with each other, and cannot know what the other divisions are doing. Traders cannot know what researchers and analysts are working on.
How can you hold a person, even a senior research analyst with $100 million, financially responsible for something they could not legally know of and had no control over? It would be illegal for the analyst to know what risks the trader is taking, yet somehow she is to be held responsible for his blowing up the company?
The stupidity of my fellow liberals abounds.
June 25th, 2009 at 11:13 am
Thanks Mr. Yglesias. After reading this one entry I can be certain that even if your subsequent articles are half as bad, they will still not be worth reading. You have saved me from wasting future hours reading your blog.