Heads: the risks pan out, the executives look like geniuses, and they have “earned” their multimillion dollar bonuses and Cuban cigars. Tails: the uberderivative financial instruments that these “geniuses” have concocted crash, as in the subprime mortgage crisis…
There are simply no negative consequences. Financial institutions, three years since the beginning of the global financial crisis, are still making incredibly risky investments (*cough* MF Global *cough*). Why? Because there’s no disincentive—moral hazard, as it’s called. Bonuses given to these banks allow and encourage risky investments. The penalty if they fail? Oh, a few billion dollars in bailout money, straight from the pockets of taxpayers. But the bonuses, they shrink in the aftermath, right? Right?! Nope.
The combination of bonuses and bailouts creates a “heads I win, tails you lose” scenario for big bank executives. Heads: the risks pan out, the executives look like geniuses, and they have “earned” their multimillion dollar bonuses and Cuban cigars. Tails: the uberderivative financial instruments that these “geniuses” have concocted crash, as in the subprime mortgage crisis; lenders and shareholders, and eventually taxpayers are forced to pay to revive the “too big to fail” institutions. Meanwhile a year after the taxpayer-sponsored recovery, bonuses rise to their highest level in history. Forget a slap on the wrist, Bank Executive Stevie just got caught with his hand in the cookie jar and his “punishment” was a trip to Costco to buy more.
In yesterday’s New York Times, Nassim Taleb’s OpEd piece touched on an important concern. To eliminate the moral hazard, either the bonuses or the bailouts must go. The easier solution for him is the bonuses, which he argues should be eliminated at any institution eligible for a taxpayer bailout. If you’re “too big to fail,” you’re too big for bonuses. At a bare minimum, this would eliminate the positive incentive for risk taking.
Of course, the second prong of Taleb’s argument—essentially instatement of the Volcker Rule—would be much more powerful. Tell the institutions: “You can bank, or you can invest. But the entities that store taxpayer money cannot also be the biggest gamblers in our financial system. Period.”
Assisted by Rachel Grossbaum