Banking and the Moral Dilemma

As Wall Street and the major European banks — led by the newly notorious Goldman Sachs — report record quarterly results and record bonus accruals, the public and policymakers have grown increasingly frustrated.

Their outrage stems from incredulity. How could institutions saved by the taxpayer 18 short months ago possibly be paying out staggering bonuses now, to the very people who caused the crisis? Moreover, how did these institutions come to make so much money in the first place?

In parallel to this outrage is the growing realization that a globally coordinated approach to bank regulation is unlikely. As a result, governments and regulators will be restricted in their ability to address some of the core issues because of jurisdictional arbitrage, and may be viewed as taking insufficient action to “do something about the banks.”

Perhaps as a consequence, the authorities have adopted an increasingly retaliatory posture. This includes some extraordinary actions, such as the pursuit by the SEC in April 2010 of Goldman on fraud charges in the U.S., unthinkable only a few months ago.

More generally, policymakers on both sides of the Atlantic are looking at punitive new tax measures. The bankers have responded with the increasingly defiant claim that they are victims of the war for talent, merely doing what it takes to ensure they have the best people to do “God’s work.”

Meanwhile, still unanswered is the most critical question: Why did the system go out of control in the first place? Most bankers surely understood that taking such unprecedented risks might result in catastrophic institutional failure and enormous loss of personal wealth.

Why wasn’t that enough to keep them from taking the course they did? If global policymakers better understood the answer to that question, they would be able to take much more effective measures.

The real answers to these questions have less to do with villainy or lax supervision than with inherent moral hazard. Addressing this hazard would be the right reason for political leaders and the boards of banks in the U.S., Europe, and elsewhere to be interested in bankers’ compensation.

Today, the urgent question that remains unanswered is whether the proposals that are moving ahead will address moral hazard adequately and thus prevent another systemic crisis.

There is clearly a mismatch between the traders’ interests and those of the bank’s shareholders and the taxpayers who are the underwriters of the state’s implicit guarantee of these institutions.

The solution may lie, not in aggregate, rules-based regulations but in a reassessment, within each bank, of how the “triangle” principle should be applied; that is, how to interweave the ways risk is taken, people are paid, and capital is allocated, and hence the share of profits that goes to insurance, to compensation, and to shareholders’ accounts.

Instead of shifting the burden of judgment to Solomonic regulators, this approach would better harmonize individual and institutional incentives. When bankers have reason to pay attention to the true economics of their trades, they will make better trades.

By aligning incentives for traders with the long-term stability of the institution, the interests of long-term investors and the system at large are also likely to be better looked after.

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