Thought of the Day (2)

                                                                                                                                                                                      Sydney M. Williams

Thought of the Day (2)

January 14, 2010

Artificial penalties, such as fees or higher taxes, as a means of reining in banker bonuses will never work. The better course is to encourage a change in the environment within which bankers operate. Andrew Ross Sorkin, author of Too Big to Fail, in an article in yesterday’s New York Times, clearly delineated the nefarious trading practices of Goldman Sachs’ fundamental strategies Group (an attitude confirmed by Lloyd Blankfein’s testimony when he stressed the importance of his proprietary desk over customer business and fiduciary responsibility). It is clear that the desk is run for the employees of Goldman, at the expense of their customers and with the U.S. taxpayer as backstop.

The simplest, least costly and most effective way to change the culture is to remove the label “too big to fail.” If bankers realized that their leveraged bets risked the bankruptcy of themselves and their organizations, one can be assured dangerously risky bets would disappear – along with the potential for outrageous paychecks. Jonathon Macey, in yesterday’s Wall Street Journal, writes that President Obama’s policy (despite his rhetoric) confirms the importance of big banks to our national interest, thereby suggesting they are too big to fail. Such an assurance from the government only encourages them to making risky bets. Professor Macey also writes: “The public shareholders of these companies tend to be diversified against the risk of failure at any particular institution.” His argument is that most of the stock is held by large institutions, not individual investors. There is, therefore, no natural governor on reckless behavior.

Robert Reich, writing in yesterday’s Financial Times, points out that no one “is talking seriously about using antitrust laws to break up the biggest banks – the traditional tonic for any capitalist entity that is ‘too big to fail’.” In my opinion, if a bank is too big to fail, it is too big. As banks increase in size, regulators should increase capital ratios. In the fall of 2008, Morgan Stanley and Goldman Sachs became commercial banks, allowing them access to the Fed window. That status brings with it reductions in leverage. And the capital ratios should incorporate all off-balance sheet items.

At the end of day, there is nothing like the threat of bankruptcy to maintain prudent lending practices, which has the side benefit of keeping excessive compensation in check. The problem of “fat cat” bankers would simply disappear.

Free capitalism only works with a carrot and stick – the carrot of success and the stick of failure.