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Fix Wall Street with a Single New Rule

October 16th, 2010 Leave a comment Go to comments

Despite the proclamations from Obama and the democrats that they passed “the most sweeping financial reform since the Great Depression”, very little has actually changed in the way Wall Street does business. The incentive structure that rewards employees for creating financial bubbles that eventually burst and cost taxpayers billions of dollars remains firmly in place. Not only that, but now that the precedent has been set that if Wall Street crashes the economy absolutely no harm will come to any of them personally, things may actually have gotten worse.

Wall Street firms are gearing up to hand out 144 billion dollars in bonuses this year. Wall Street bankers will be taking home tens of millions of dollars not because they earned it or that their talents are actually worth it, but because they’ve simply created this wealth out of thin air and don’t have to worry about losing it. If something goes wrong—and it almost certainly will—it’s the schmucks who can’t afford to buy half of Congress who’ll have to pay.

To the Wall Street types it’s nothing more than a game. There are winners and there are losers, and abstract concepts like morality and social responsibility don’t enter into it. They’ll make their strategic calculations and take the course that leads to the best financial outcome for them, even if it’s the worst possible outcome for everyone else. The only way to change the outcome of the game is to change the rules.

But it doesn’t need to be a huge, complicated piece of legislation. If we just impose one new rule on Wall Street—one that happens to be simple enough for everyone to understand—it could change everything.

William D. Cohan is the author of House of Cards: A Tale of Hubris and Wretched Excess on Wall Street. I caught him in an interview with Cenk Uygur who was filling in for Chris Jansing on MSNBC this past week, and found his suggestion to be rather brilliant.

The idea is to take the top 100 people at the Wall Street firms, the ones who make the decisions about what businesses to be in, how to deploy capital, who to hire and fire, and make them sign an agreement that they’ll put their entire net worth on the line. They’ll have to create a security out of their own personal money that would be the first thing to disappear if something goes wrong. Yes, the taxpayers would still be on the line for however many billions their reckless behavior costs the economy, but the first few hundred million will have to come directly out of their pockets.

What could be more reasonable than forcing these gamblers to actually gamble with their own money? If we do that, the incentive structure changes entirely. Yes, they can keep creating these bubbles and raking in massive amounts of short-term profit by putting the economy in jeopardy, but if they go too far and it all comes crashing down, their mansions and yachts will be the first things to go.

Right now, Wall Street bankers take all of the gains and suffer none of the losses. They’ll get their bonuses no matter what economic harm they do. But if we change the game slightly so that they’ll have to suffer the losses before anyone else, they might not want to take such huge risks. They might want to play it safe instead, to slowly accumulate wealth as the economy slowly accumulates strength. The rising tide really would life all ships in that case, rather than the way it is now with Wall Street tilting the oceans so that all of the water flows to their end while grounding the ships on the other side.

Cohan suggests that the Wall Street firms take it upon themselves to make such an agreement because it would be good for business. Investors would feel far safer putting their money in a financial firm run by people who have even more at stake than they do. It would be wonderful if a few firms started doing this and the rest were forced to follow suit.

But apparently no Wall Street firms are willing to take that risk. They’re perfectly willing to risk other peoples’ money, but not their own. That can only mean that when they make their strategic calculations they assign a high degree of probability to another financial crisis happening, otherwise there’d be no harm in making such an agreement. But they know they can make more money by inflating the bubbles and dealing with another crisis than by going back to safer tactics. With the rules as they currently exist, we guarantee another crash because another crash is in the bankers’ best financial interest.

All we need to do is change their incentives, and if they won’t do it willingly we have to impose this rule on them. Make them put their own net worth on the line, make them financially responsible for the things they do, and watch as they start doing things more responsibly.

No big pieces of legislation necessary. Just one quick fix, one proposal that everyone can understand and that would therefore be extremely politically difficult to oppose. There’s no reason this proposal can’t be made. We just need one representative willing to make it.

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