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.