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(originally published by Booz & Company)


Solving Moral Hazard in Banking

Proposals to tax and regulate bank compensation are fast gaining momentum, but they fail to address the core issue.

As Wall Street and the major European banks — led by the newly notorious Goldman Sachs — report record quarterly results and record bonus accruals, the public and policymakers have grown increasingly frustrated. Their outrage stems from incredulity. How could institutions saved by the taxpayer 18 short months ago possibly be paying out staggering bonuses now, to the very people who caused the crisis? Moreover, how did these institutions come to make so much money in the first place? In parallel to this outrage is the growing realization that a globally coordinated approach to bank regulation is unlikely. As a result, governments and regulators will be restricted in their ability to address some of the core issues because of jurisdictional arbitrage, and may be viewed as taking insufficient action to “do something about the banks.”

Perhaps as a consequence, the authorities have adopted an increasingly retaliatory posture. This includes some extraordinary actions, such as the pursuit by the SEC in April 2010 of Goldman on fraud charges in the U.S., unthinkable only a few months ago. More generally, policymakers on both sides of the Atlantic are looking at punitive new tax measures. The bankers have responded with the increasingly defiant claim that they are victims of the war for talent, merely doing what it takes to ensure they have the best people to do “God’s work.”

Meanwhile, still unanswered is the most critical question: Why did the system go out of control in the first place? Most bankers surely understood that taking such unprecedented risks might result in catastrophic institutional failure and enormous loss of personal wealth. Why wasn’t that enough to keep them from taking the course they did? If global policymakers better understood the answer to that question, they would be able to take much more effective measures.

The real answers to these questions have less to do with villainy or lax supervision than with inherent moral hazard. Addressing this hazard would be the right reason for political leaders and the boards of banks in the U.S., Europe, and elsewhere to be interested in bankers’ compensation. Today, the urgent question that remains unanswered is whether the proposals that are moving ahead will address moral hazard adequately and thus prevent another systemic crisis.

Taken collectively, in spite of many valid objections, by and large the suite of proposals emerging from the Financial Stability Board, the International Monetary Fund (IMF), the Institute of International Finance, and other supervisory organizations around liquidity, leverage, capital, and even taxation would move us forward toward a regime with more stability. An endemic problem is the policy preference for across-the-board rules, applied at a minimum to “systemically important institutions” irrespective of institutional risk profiles. Aggregate rules are right on average, and wrong in particular cases, every time. Two institutions with balance sheets of similar sizes — one a big fixed-income trader and the other a trade facilitator — will have profoundly different risk profiles and deserve very different controls. Moreover, even among institutions with similar business mixes, the evidence is overwhelming that some of the small handful of systemically important institutions were much better risk managers than others. There is therefore a strong case for a more nuanced approach, as proposed by Adair Turner of the Financial Services Authority, for examining the risk behavior of each institution and regulating it accordingly.

The fundamental problem with these approaches, however, is that the measures are inadequate on their own. This is because they implicitly assume that banks are unitary entities that respond to the incentives supplied by the regulator. They do not address the reality of large, decentralized, multi-line global banking institutions, which is that no administrative checking mechanism can effectively supervise such a complex institution. Instead, any successful regime must address both the aggregate institutional requirements and the microeconomics of risk taking when faced with asymmetric information within the institution. The only way that regulators — and, more important, boards and managements — can exercise supervision over such complex institutions is to address the core problem: the disconnect between capital reserving and particular risks borne by banks and compensation structures (especially those of traders), and the lack of alignment of these mechanisms with the institution’s interests. This is the sense in which the proposals do not adequately address moral hazard.

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