Neil H. Buchanan

Financial Market Reform: Two Goals, No Frills


Thursday, October 8, 2009

Back in the 1980's, during one of several merger frenzies in the banking industry, I was talking with one of my economics professors about the trend toward fewer and larger banks. Although I thought of this as a worrisome development, my professor assured me that it was merely the market's squeezing inefficiency out of the system. "What good," he asked, "does it do to have so many banks, each with its own army of junior vice presidents?"

We now have an answer to that question, as well as to the premise on which it relies. While it is true that there is duplication of functions and personnel when there are many banks, having larger numbers of smaller banks reduces the likelihood that any bank will achieve that now-infamous status: Too Big to Fail.

Keeping some loan officers and account managers on the payrolls of some small banks, in other words, might be inefficient in a micro sense. But having a few large banks that can bring down the system, by contrast, takes the whole notion of market failure into the macro realm. Financial fragility, we now know with frightening certainty, increases as the number of institutions shrinks and their sizes grow.

Congress has begun to turn its attention to the re-writing of our financial laws, in an effort to prevent a repeat of the near-death experience of the U.S. and global financial markets in late 2008 and early 2009. As it does so, it should bear in mind this tradeoff between "small waste" and "big danger." This means directly confronting questions about the size of our financial institutions. Indirectly, it also means squarely facing questions about how our financial players are compensated.

For both questions – "How big should banks be?" and "How high should salaries be?" – the most important point to remember is that Congress should not be afraid to wield a blunt instrument. Arbitrary limits are needed, and once passed, they should be implemented quickly.

Too Big to Fail and Too Important to Ignore

We have learned to our regret in the last year just how important it is not to allow the financial system to become seriously unbalanced. The issue is not just that there were a small number of large financial institutions – commercial banks, investment banks, insurance companies, etc. – that had become dominant in the markets. It is also that financial markets themselves are so important that they must be bailed out much more quickly and aggressively than any other part of the economy.

Consider the bailouts of the U.S. automakers GM and Chrysler. Those who supported the bailouts did so because there were too many jobs at stake, and too many communities that were at risk, if the two companies were allowed to fail. There was some concern that the economy could go into a further tailspin as jobs were lost, but it was also thought that even if no such feedback loop ensued, the consequences to the economy of these automakers' failures would simply be too severe, purely because of the size of the companies in question.

By contrast, the financial sector could require government intervention even if there were no dominant players in the industry – only a host of small and medium-sized players. That's because large-scale losses of confidence in the financial system can lead to "contagions" that threaten not just the jobs of the people who work for financial institutions, but every single job in the economy. All businesses rely on the flow of credit (to meet payrolls, or to pay bills while waiting for payments from customers, for example), so a threat to the financial system is a threat to the economy and everyone in it.

Because the financial system is so central to the health of the economy, the presence of extremely large institutions in those markets thus creates an additional level of danger – and an additional possibility of the kind of catastrophe that will result in the government's needing to jump in to save the day once again. A run on a small local bank can be contained with the standard regulatory tools (cash infusions, etc.) and some cover from other local banks, allowing the threatened institution either to survive or to fold without incident as customers move to competing, healthier banks. If, however, one bank is so big that it alone can set off a contagion, then it is in a very real sense too big.

The Size of Banks Should Be Limited So None Are "Too Big to Fail"

If we were to limit the size of banks, would there be any tradeoffs? Another argument for allowing banks to grow in the 1980's was that they needed to be big enough to compete with large Japanese banks. Only by allowing such mega-institutions to form, it was said, could we be confident that U.S. finance would remain competitive.

But, as we now know, those big Japanese banks – like the once-feared Japanese economy itself – are no longer positive role models. Being big, bigger, biggest, it turned out, was not the path to success.

As Congress considers how to re-write the rules of our financial system, therefore, it should not hesitate to start from a basic principle: No financial institution should be so big that it could ever be, from a regulatory standpoint, too big to fail.

Of course, this rule will be especially difficult to implement now, because of the consolidation at the top of the industry that followed from last Fall's crisis. Even so, Congress must take seriously its responsibility to prevent future crises. Through aggressive enforcement of antitrust laws, regulatory penalties for excessive size, rewards for splitting up large institutions into smaller ones, and whatever other solutions prove necessary, the financial industry must become less top-heavy.

Salaries, Bonuses, and the Financial Crisis

The second major area of concern, when it comes to financial market reform, is the salaries and bonuses that are earned in the financial sector. There is no remaining doubt that money managers and financial executives had strong financial incentives to engage in large risks. Too much of their world amounted to the classic "Heads I win, tails somebody else loses their money" pathology.

The compensation schemes on Wall Street were dangerous and ultimately caused behavior that nearly brought down the global capitalist system. Even so, many economists and spokespeople for the financial industry continue to argue that it is inappropriate for Congress to try to regulate salaries in any private industry. Instead, the suggestion is that, at most, financial firms should be given incentives to change the way their workers are paid, so that pay structures better align the interests of financial players with those of their customers (as well as those of the economy as a whole).

This resistance to the regulation of salaries is, in part, based on the notion that only properly-motivated owners of firms can know how best to bring out the creativity in their workers. Thus, it is often argued that if Congress rules out certain types of compensation (for example, stock options) it might not be possible for a firm to provide the proper incentives to its most important workers, causing them to produce at the highest level and to stick with the company long-term.

Similarly, if Congress were to put arbitrary limits on the sizes of salaries, bonuses, and overall amounts of employee compensation granted by certain types of firms, the worry would be that some workers would not work for those firms at all, or would not work as efficiently as they otherwise might.

Notice that the issue here is not the question of high income concentration. If we were truly concerned about that, we could deal with it through changes in income taxes and wealth taxes. The question here is about poor incentives. If extraordinarily high rewards pull too many people into the financial sector, and if they encourage people to take too many risks, then we need to adjust the payments both downward and toward less risk-inducing types of payment schemes.

Interestingly, the evidence suggests that, in fact, people in these industries view their payments as scorecards, as proof of who is winning and who is losing. If that is true, then there is no psychological difference between paying someone $500,000 while paying another person $1,000,000 and paying them $5,000,000 and $10,000,000, respectively. It is all a matter of relative position.

Don't Get Cute: The Possible Solutions Should Not Be Nuanced

The issue of workers' pay thus shares with the issue of firm size a key strategic requirement: The solutions should be simple, even if they paint with a broad brush. Yes, it is true that we could imagine working out an algorithm by which we could determine the ideal size of a financial firm, just as we could imagine the creation of a perfect set of financial incentives for such firms' workers. The likelihood of finding those golden means, however, seems vanishingly small.

The better approach is simply to achieve a few basic goals. This means that the law Congress passes to change the regulation of financial institutions should include simple definitions of "big": When are firms too big, and when are salaries too big? The law should err on the small side, and it should be clear in setting maximum sizes.

Ultimately, setting the sizes of banks and setting constraints on salaries and bonuses will not be an exact science. Some readers may then ask, Why be so arbitrary? Is it not true that there is little difference between a salary of, say, $1.01 million and $0.99 million? Why draw arbitrary lines?

But the fact is that we draw arbitrary lines all the time. If a student enters a college that requires, say, 120 credit hours to graduate, she will not receive a degree if she stops at 119 hours. Is there really an important difference that lies in that very last hour, some key piece of knowledge that stands between being truly educated and remaining hopelessly ignorant? Of course not. Similarly, when a person takes a driver's license examination, the difference between a score of 76 and one of 74 can be the difference between driving and walking, even though those two points probably mean little in terms of the public's ultimate safety.

In other words, this is one of those times when we need to adopt rules, rather than standards. Congress must tell financial firms, "You must be no taller than this line in order to go on this ride," not, "You need to act responsibly." It must say, "Executives cannot be paid more than X dollars," not, "Executives must be given appropriate incentives."

It would be nice if we could be more fine-grained, but recent experience indicates that the most important changes in the regulatory system must be simple and blunt. There will be many details to work out, but we at least know that – for both financial institutions and their highly compensated employees – big really is bad.

Neil H. Buchanan, J.D. Ph. D. (economics), is a Visiting Scholar at Cornell Law School, an Associate Professor at The George Washington University Law School, and a former economics professor.

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