Friday, February 25, 2011

How to regulate the financial industry?

Historically the path Congress has chosen for regulating the financial industry has been based on creating a Government agency to set rules and make sure the industry obeys the rules.  History also demonstrates this method works for awhile, but eventually either the industry finds ways around the rules, or we the public (and our representatives) forget why the rules were created and allow special interests to water them down, or eliminate them.


Part of the problem is the rules are aimed at corporations.  People with money put their money in corporations because government created a special rule for corporations 150 years ago or so.  If you put your money in a corporation you are protected from losing any more than what you put in, so you are willing to take more risks.  Historically that has usually been a good thing.  The possibility of losing their investment is enough to make investors strike a balance between risk/reward and disaster/loss.   


But financial corporations have become so large, and markets so efficient, that this balance has repeatedly failed to prevent disaster.  The ownership of big financial corporations is so diversified the investors lose touch, and influence.  If you don't like the company you sell and move on.  As a result management now effectively controls the corporation.  The diverse and uninvolved ownership base cares only about how much money you make right now, and are willing to pay buckets of money to management who produce.  If management does not have an ownership interest in the company, the disaster/loss side of the equation is minimized, the risk/reward part of the equation is emphasized.


Sure some CEO's lost their jobs after the 2008 meltdown.  But they just lost a paycheck, they walked away with millions of dollars in pay and bonuses they realized from the excessive risks they were taking.  


I think regulation that will work for the financial section should focus on management, not on the company.  Set up a carrot and stick approach that aligns managements interest with the long term stability and health of the company instead of the short term profits.  Here is an idea:


Require management compensation that exceeds a certain threshold to be taken in corporate stock, and require that the stock be held in trust, with the corporation as the beneficiary, for some set number of years before it could be sold.  Management could spend any dividends that accumulate in the trust after the dividend was paid, but the principal would be held in trust and subject to return to the corporation in the event of financial disaster.


This would insure that management was a stakeholder in the long term health of the company, not a hired gun out to make as much money as possible before their good gig blows up in their face.  Make it in managements interest to focus on long term profitability and stability as much as risk/reward. 


This could be done with tax policy by setting very high marginal rates on compensation taken in cash over some threshold, or alternatively by creating an exception to the limited liability rules applicable to corporations which would require excess management compensation be placed in trust as an asset that could be reached by creditors.


Of course I am not betting anything other than business as usual will happen, but I can dream,  and I can warn the younger generation to be on the alert for the next big economic blow up as financial regulation predictably fails down the road.  



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