Shak: Bankers are too reckless

If you give someone $10,000 to gamble in a casino every morning and he leaves every night with either a percentage of any profits or nothing at all, he can’t be expected to play conservatively.

As this economic crisis has persisted, we have become increasingly aware of the dangers of moral hazard, the concept that when someone is protected from downside risks he behaves irresponsibly. There is little doubt that moral hazard contributed significantly to the near-meltdown of the world financial system. Seat belts and air bags, it seems, inspired reckless driving.

When the government bailed out AIG and the rest of the United States’ banking system, it issued an implicit guarantee — the U.S. government would prevent banks from feeling the full negative effects of risky lending in order to save the system. As we re-emerge from the abyss, the question remains: How can we prevent banks from acting irresponsibly if they know the government will save them should their investments not pan out?

Many policymakers now call for an end to the era in which banks represent systemic risks and are “too big to fail.” By creating a system with increased governmental regulation of larger banks, this goal may be accomplished. No bank will be able to act irresponsibly enough to bring down the entire financial system.

Supposedly, the government would be able to prevent banks from engaging in risky behavior by banning that which is too risky. Politicians are already working on ways to control the use of credit default swaps, an important catalyst in this crisis.

But the elegant concept of having the government prevent private bank indiscretions will not be enough to prevent economic meltdown from happening again. Regulators need only fail to identify one instance of excessive risk, and the entire system could come crashing down again. Just as the government failed to foresee the dangers of junk bonds and subprime mortgages, it will not recognize when bankers legally circumvent regulations and act recklessly in the future, sowing the seeds of economic destruction.

The only effective way to prevent moral hazard is to force banks and bankers to put more skin in the game. People handle money much more prudently when their own personal finances are at stake. Obviously banks should be fully responsible for the losses they incur, but poor decisions start with people, not corporations. Therefore, we need to prevent individuals from investing in ways that they would not invest their own money.

Investment bankers and other financiers also need to be held more personally responsible for the business decisions they make. In the end, institutions take on too much risk knowing that the government may save them from disaster, but individual bankers also act irresponsibly in pursuit of large performance bonuses. They know they could stand to earn huge performance bonuses and cannot suffer personal financial harm from the transactions they make. Playing with the house’s money, whether it is that of the government or a client, is an inherently unstable strategy.

As painful as it is, new methods of employee compensation must be devised at investment banks. Bankers should receive large performance-based bonuses, but they should also stand to lose if their investments fail. The tremendous incomes of Wall Street bankers are not sustainable unless salaries and bonuses are tied to performance, exceptional or pathetic.

Marcus Shak is a freshman in Pierson College.

Comments

  • Why does the YDN print such bad columns

    This column is absolutely horrible. It just reeks of a freshman who just took his first intro econ classes (probably intro micro based on the moral hazard reference). In this column, Marcus Shak presents a summary of popular ways that have been put forth to deal with the financial crisis, and not even the best ones. His statements, (I would call them ideas but they are not his own, simply copies from the NYTimes, CNBC and the Economist), do not deserve to be in a newspaper like the YDN, or any newspaper at all, since they don't include original thoughts. Literally, Shak's column could be titled "How to make banks successful according to a student of intro econ courses". The problem with the system suggested by Shak, in which pay is almost entirely incentive based, is that it transfers the risk (variability in pay) to the employee or I-Banker. As a result, banks would either have to pay MUCH more money to retain an equally qualified employee, or lose them. This is not competitive. If anyone is proposing strict rules on bankers pay, like Shak and may others essentially are, think about it this way. If Lehman Brothers could have hired Lloyd Blankfein (the current Goldman Sachs CEO) at 10-times his Goldman salary three years ago to work at LB instead of GS, he probably would have accepted the offer. As a result, instead of LB wiping out hundreds of billions in equity under Dick Fuld, they could have still been profitable like GS is now instead of being bankrupt. (I realize that the issue is much more subtle and that statement isn't pure fact, but we can at least agree that Fuld messed up while Blankfein did well). The way banker's pay currently is allows banks to compete over the best people. A legitimate proposal should implicate the government as the root of the problems we face. An excess of available capital allowed banks, as well as many other individuals and institutions, to take on too much debt. This resulted in an excess of volatility in the markets, which combined with high levels of debt, resulted in extremely high profits (2007) and then (near) bankruptcy for many firms (now). We just need to get better at counter cyclical economics, as Keynes told us over 80 years ago.

  • @ #1

    Actually, moral hazard IS an important aspect of this crash that has been inadequately addressed at this point. You would be example number one of why this article should have been written, as the message clearly hasn't sunk in.

    By the way, while Shak may indeed be taking Intro Econ (where, by the way, you DO learn lessons applicable to life), you reek of the overinflated ego of a future (current?) investment banker.

  • @ @ #1 aka @ # 2

    I am well aware of the role of moral hazard in the financial crisis. However, my point is that this is obvious and has been covered 10000 times by every media outlet in the country. This article doesn't give any original insight, nor does it summarize an issue which most people know little about. Thus, it is horrible. I understand that the author wants to be involved in the paper, but the YDN should not publish something like this which is completely not worth being printed. It would be like them printing an article which stated "a lack of focus on al Qaeda allowed 9/11 to happen". Anyone worth speaking to already knows this, and any newspaper worth reading would have no reason to print this article. Leave articles about economics to people who actually know stuff about economics. And no, I am not currently nor will I be an investment banker (or worker in a finance-related field) any time soon.

  • BK Alum

    I agree with the previous commentor that this article is a strikingly elementary recount of what's out there in the popular press. While I believe that the message is correct, ie moral hazard was a factor, this article reads like it was written by some high schooler pressed for time who just read about the concept moral hazard. Come on guys, really?

  • Agreed

    Agreed. Certainly Shak needs to realize that the YDN is the #1 college newspaper in the country, and he simply isn't qualified to write this type of column for them yet. Maybe one day, but today he lacks the knowledge of the crisis and economics background to address it properly. Maybe he should write about campus events and such until he is fit to be a "business columnist", as the column claims he currently is. Good effort though, but maybe he should leave this type of column to the grownups.

  • Is he qualified?

    I agree. This article is not very well-written and doesn't say much at all, though some of Shak's other articles do seem to indicate that he does have some grasp of what's going on, like this one:

    http://www.yaledailynews.com/articles/view/28117