Wall Street Regulation vs. Capitalist Incentive

by: Cam Hui, CFA

There has been a lot of hand wringing lately about how the efforts to regulate Wall Street have gone nowhere (see example here). We’ve had the likes of Paul Volcker weighing in on what banks shouldn’t be allowed to do because of the effect on systemic risk. There have also been various proposals on regulating compensation on Wall Street.

The approach is all wrong.

Wall Street = Pure capitalism
Wall Street investment banks are the embodiment of capitalism in its purest form. The question is: “How do you prevent systemic risks from building in the system and encourage innovation at the same time?”

One example of recent innovation is the attempt by some investment banks to package and trade life settlements. David Merkel of Aleph Blog thinks that it’s a bad idea. Widespread trading of these instruments will create unintended effects:

Think about it: you as the insurance company did your best job to estimate the risk involved. You did it assuming that policies could not be sold, whether really or synthetically. You already knew that those who were healthy in the future would surrender and seek another carrier, but thought the those who were less healthy would persist to some degree. Well, with life settlements, the unhealthy persist at a much higher level, which bites into profits.

This is the box that life insurers are in. They can’t lock in policyholders, but policyholders can hang on, refinance (so to speak), or sell off their obligations. That is a tough equation for life insurers to work through, and to the degree that life settlements are allowed, premiums will have to rise to compensate for the loss of profitability.

People respond to incentives
Right now, the Wall Street incentive system is overly asymmetric. Instead of constraining banks on what they should or shouldn’t do, regulators should set up a system that more naturally regulates behavior.

The solution is really simple: Bring back the partnership investment bank. Consider this old article about the partners of Goldman Sachs (NYSE:GS) discussing the issue of whether the firm should go public [emphasis mine]:

Others, including John L. Thornton, a member of the executive committee, spoke with equal determination against any public sale of shares, people there said. The prime fear was that a public company could never replicate the close-knit culture of a partnership, where financial rewards are measured in lifetimes instead of months

Every company talks of teamwork, but Goldman elevated it to a commandment, bankers there say. Because partners' own money is at stake in every deal, the firm operates by consensus, with top executives often able to trust other partners implicitly. Scores of Goldman people participate in decisions that one or two bosses might make in other firms.

Investment banks lost their way once they became public companies. The compensation of its traders and executives became more and more asymmetric. In effect, they were given call options on the cash flow of the firm. Being human beings, they behaved accordingly. At the same time, there were fewer and fewer incentives to exercise adult supervision.

Society should be telling Wall Street the following: "You are free to innovate and make piles of money. If you make the wrong bet and take on too much risk, then you are free to blow your financial brains out. But if you blow out your (metaphorical) brains, don’t splatter it all over my living room so that I have to clean it up. "

Bringing back the partnership investment bank solves most of those problems.