The Best Way To Reduce Risk In The Banking System Is To Stop Rewarding It

cigar banker

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In the previous section I argued that some opponents of a stock transaction tax bill actually give evidence that supports the imposition of such a tax since their proposed cost—a 10% drop in the stock market–is in fact unlikely to occur.I further state that the imposition of a trade tax would actually have ancillary benefits greater than even the costs of a 10% market drop–specifically in terms of re-allocating valuable resources away from stock trading.

However I think there is a better way than imposing a transaction tax to create the same benefit of reducing the size of the financial sector—a way that would further achieve a much desired goal of reducing the need for future bank bailouts.

Revenue from a transaction tax would not reduce the probability of future bailouts. Using today’s 2.5bb NYSE volume and assuming an average share price of $35/share, applying a .25% tax and assuming the tax cuts volume by 50%, the daily revenue would be $109mm, for annual revenue (assuming 250 trading days per year) of about $27bb.

Over a 10-year period the kitty would hold about $270bb, which does not come near the $2.5 trillion to 12 trillion (a range that encompasses virtually all estimates) that the government used to plug all the holes in the sinking financial system in 2008 and 2009. The needs were so large that it’s obvious that if we are going to eliminate the need for taxpayer-financed bailouts in the future, we will need to prevent the holes from developing in the first place.

It seems paradoxical that the banks in generating such large revenue growth between 1990 and 2007 could have been susceptible to bankruptcy en masse in 2008. But it is not a paradox when one considers the nature of banking systems– many years of profits can be permanently undone in a panic if sufficient reserves are not on hand.

There were many reasons banks did not have sufficient reserves in 2008 but ultimately capital requirements were too low given the risk the banks were taking. The former was enabled by the powerful bank lobby, the latter encouraged by the asymmetric compensation packages on Wall Street. If we are stuck with lobbying as a feature of U.S. politics, then we must eliminate the asymmetric compensation packages in order to ensure banks take risk commensurate with their reserves.  

A tax on trading does not reduce the risk in the banking system. Though the tax will reduce high frequency trading, a reduction in high frequency trading does not reduce risk — high frequency trading, a form of short-term market making, is profitable in all environments and more so in times of crises as bid/ask spreads widen. (High frequency trading enjoyed large profits in 2008.)

However there is a way to discourage actual risky activities: mandate a permanent claw back on compensation for any bank employee, particularly those that are paid based on trading profits.

Currently the compensation model is that proprietary traders, those risking the bank’s assets, are paid roughly 15-20% of their profits. The key element in this model is that their compensation can only be positive, and thus their payout is asymmetrical.

Morality aside, the trader has incentive to take maximum risk because in a year where he has enormous profits he becomes egregiously wealthy and in year where he has enormous trading losses he forfeits not a penny. And it is not just the traders that are paid asymmetrically–everyone at the bank from the lowest clerk to the CEO participates to a certain extent on the upside but not the downside (given implicit bailouts) and it is in none of their interest to dissuade traders from taking undue risk.

The addition of a clawback requirement would eliminate this asymmetry and put real brakes on the risk traders and their bosses are willing to take. In fact, a clawback in and of itself would eliminate the need for what is becoming an overly unwieldy Volcker rule. If the aim of the rule is to eliminate risky activity so as to reduce the risk of bank failure and subsequent bailouts, a clawback addresses this on its own.  There is no need to debate what is or what is not a market making activity, or to hash out specific reserve requirements. If traders (and CEOs) have their own money at stake they will act with proper prudence.

The execution of the clawback provision is simple: it would require that some meaningful amount –I’d start with 60% for the highest earners, less for others– of a trader’s annual compensation is put in escrow (perhaps earning interest contingent on the performance of the firm’s own short term debt) until such time as the trader is no longer carrying risk (i.e. when he has left the firm and all his positions have run off). In the meantime those retained payouts will be subject to claw backs in the event the trader subsequently loses money. This is not difficult to implement and in fact would look a lot like the partnership deals bankers had before the investment banks went public in the 1980s and 90s. The investment banks didn’t metastasize into their too big to fail bulk until they went public. (And the commercial banks not so until Glass Steagall was repealed in the 1990s, which is a matter for another day).

 In fact no partnership received bailout money during the crisis, including the largest hedge funds. Under the clawback regime instead of traders taking cash out immediately their capital accounts would grow and grow so long as they were profitable, and would be reduced an amount equal to their losses if they were not, and would be fully theirs only when they were no longer carrying risk. It may seem that a mandatory clawback seems an encroachment upon free market capitalism. However, in reality it restores the banking system to a free market condition—bankers return to participating on the upside AND the downside, and the need for implicit bank bailouts, a decidedly non-free market aspect of our economy, recedes.  

With the implementation of mandatory clawbacks star performers would still become quite wealthy while marginal performers would not, which means the banking sector would no longer attract a superfluous amount of talent at the expense of other sectors and the banking system would no longer impose an undue risk on the U.S. economy. A handful of investment banks have implemented a modified clawback provision (roughly 60% of bonus withheld 4 years and subject to clawback). This is a good start but the provisions need to expand their time frame (in 2008 many traders were responsible for losses bigger than their previous 10 years’ combined profits) and to all systemically important financial firms.