It's been a while since I've posted a diary based on a column by my homeboy Alain Sherter, business columnist for bNet. The wait was, I think, worthwhile. Sherter's column "How to Beat Wall Street at Its Own Game", introduces us (well, at least me) to a new paper published by two law professors at the University of Minnesota, Claire Hill and Richard Painter. Hill and Painter provide an eye-opening insight into how we could make a big dent in the problem of overcompensating financial services executives. (It turns out that this was also covered in Steven Davidoff's "Dealbook" blog in the New York Times last Friday, where it fell in the forest and did not make a sound.)
Ready to do some deep thinking this evening? Here's what Sherter describes as the "neat" and "commonsensical" proposal: make bankers take on some personal liability.
The trick is: how?
Note that this diary is quote-heavy because I'm able to cannibalize three sources: the original Hill and Painter paper (which, unless you subscribe to the Social Science Research Network, you can't read through that link), Sherter's column, and Davidoff's blog. I'll give the name of each source before each quote, but the links will only be found above. Emphasis is mine throughout.
Let's start with Hill and Painter's diagnosis of our current problem -- that financial services organizations can place bets with other people's money, scoop up the profits, and jettison whatever losses ultimately occur onto the public tab, in their own words:
The public bears the brunt of the cost from excessive risk-taking by banks, but government regulation thus far has been inadequate to protect the public interest. Some form of personal liability for bankers is, we believe, something to consider: it may be a very effective way of reducing the risk taking that imposes such enormous cost on the public.
Personal liability, you say? Sounds vaguely unAmerican! But do go on....
One proposal is that bankers earning over $3 million per year be required to enter into a partnership/joint venture agreement with the employing bank that would make them personally liable for some of the bank’s debts. The other proposal is that compensation in excess of $1 million per year be paid to bankers only in stock that is assessable in the event of the bank’s insolvency in an amount equal to the book value of the stock on the date of issue.
Both of those are going to require a little explanation, and if you feel the slightest stirring of interest in this topic, please head over to the bNet link and the last part of the NYT story for better explanation than I'll provide here.
Sherter gives us the broad view here:
These approaches recognize a key, but often overlooked, factor in the debate over escalating Wall Street bonuses: How much bankers make matters less than how they’re paid. They also get at the heart of the problem, which is that top bankers are rewarded for taking large risks. Typically, the bigger the risk, the bigger the reward. Almost by definition, the most successful bankers are the ones willing to lay it all on the line, because that’s how you get ahead at, say, Goldman Sachs or Citigroup.
Davidoff in the NYT starts out his explanation by invoking Michael Lewis:
[In] structuring the compensation paid out by banks today, we have the opportunity to rework the structure, to set in place a mechanism that can work to prevent the recurrence of these practices. In prior writings, I have extolled the partnership structure of investment banks. This is the model that existed prior to the 1970s when many investment banks were private. The partnership model locked in the partners’ capital and made them personally liable if the investment bank failed. As Michael Lewis has stated in his terrific article, “The End of Wall Street’s Boom”:
No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit.
We need to find a way to roll back the clock and restore this commitment to Wall Street. Given that, a new paper has put forth an exciting idea concerning financial institution pay. Professors Claire Hill and Richard Painter have proposed that we should attempt to recreate the partnership investment banking model using substitute mechanisms.
What does he mean, "rework the structure" of corporations? Isn't that messing with nature? No, as it turns out, corporations are not natural entities! (You wouldn't know that from watching the news, but evidently it's true.) They are creatures of statute, and we through our government can, through arcane mechanisms called "statutes" and "regulations," determine how they may operate! That is, if we want to, we can water down the ability of financial services executives to hide behind the corporate structure. We can make them share the risk. They'll still be rich, they just won't act as dumb.
If you force financial services executives to operate not merely as employees who get to say bye-bye whenever the going gets tough, but as partners in a joint venture with those banks, with the attending possibility of personal liability for the banks losses if it does something like, oh, destroy large swaths of the economy, they will act more responsibly. I love the idea of using the business forms to solve a problem that is, in essence, one of business forms.
Davidoff responds to Hill and Painter's ideas thusly:
This sounds extreme, but Ms. Hill and Mr. Painter ably document how assessable stock of this nature was utilized in the financial industry prior to the 1980s exactly for this purpose. I like their proposal because it mimics the partnership structure and ties investment bankers to the firm, giving them real responsibility for its future. The mechanics of its payment and process still need to be worked out, but this and similar ideas should be thoughtfully examined.
OK, you have some idea what a joint venture or a partnership is, where both entities (human or corporate) share some risk. What's all this folderol about "assessable stock"? It turns out that it's not a new idea! Take it away, homeboy Sherter!
Another idea is that any compensation exceeding $1 million in a given year be paid in “assessable” stock. These are shares that a company can issue at one price, but later ask the holders for more money to reflect changes in the stock’s value. In other words, a banker who’s given stock at no cost or a steep discount as part of his comp would have to buy the shares at a higher price if the company eventually goes bankrupt.
So we can set the rules so that if they tank the bank, we can make them buy back the stock that they received as their huge compensation? I don't know -- sounds kind of crazy, doesn't it? Doesn't sound like the sort of thing that would ever happen in the good old U.S. of A! Wait, it looks like Sherter has something to say bout that.
The best part of Hill’s and Painter’s solution is that it’s been tried before. For, oh, the better part of a century. As they recount, until the 1980s most investment banks were general partnerships. Partners shared not only in the upside, but also the downside. If the bank croaked, their wealth died with it.
Things started to change in the 1970s. The New York Stock Exchange began to allow brokerage firms to have a public float. Companies argued that in order to raise outside capital, shareholders needed protection from unlimited liability. Over the next couple decades, investment banks ditched their partnerships to become LLCs. The last holdout, Goldman, finally converted in 1999.
We all remember what else happened in 1999, as Sherter reminds us: the repeal of Glass-Steagall, making it possible for the culture of investment banking to invade and ultimately dominate the culture of large commercial banking.
So, is the idea here that with a few simple changes, tried and true ones, that would put bankers back on the hook for their choices, we could tame the crazy and dangerous financial sector?
Yes.
Write Congress. Write the President. Let them know that some smart people have figured some important things out. Boy, you know, you could almost campaign on this stuff!