Among the most elite investment bankers and hedge, private equity and mutual fund investors, America’s economic recovery is well under way. The largest financial institutions, aided by government guarantees and huge infusions of taxpayer dollars, have been making big, risky bets that — so far, at least — are paying off. Profits at the too-big-to-fail banks are approaching levels not seen since 2007, which was itself a record-breaking year. All of this is happening, lest we forget, against a backdrop of looming foreclosures and 14 million unemployed, 4.4 million of whom have been unemployed for a year or more.
What’s galling about this isn’t so much the contrast between a flourishing Wall Street and a floundering Main Street, though that certainly rankles. It is the fact that the U.S. financial system seems no more stable today than it did before the 2008 financial meltdown. Indeed, many fear that the cascading debt crisis in Europe will be enough to bring down financial institutions on both sides of the Atlantic, causing still more economic hardship.
Anger at Wall Street is in a very real way undermining the legitimacy of the market economy. Voters are clamoring for a stronger regulatory response. The latest NBC News/Wall Street Journal poll found that 74 percent of respondents believe that the Obama administration hasn’t done enough to reform the financial system. Despite these overwhelming numbers, the main Republican presidential candidates are maintaining, to their peril, that repealing Dodd-Frank is the most important thing Congress can do.
But the rot in our financial system didn’t start with Dodd-Frank.
Recently, Nassim Nicholas Taleb, author of “The Black Swan” and a much-admired financial guru, called for banning bonuses at too-big-to-fail banks. His argument is that performance-based compensation encourages bankers to make risky bets, which may well be true.
We would do well to keep in mind a cautionary example. During the 1990s, section 162(m) of the tax code ended the tax deductibility of cash compensation above $1 million to CEOs and other top executives unless that compensation is performance-based. The idea behind this provision was that Corporate America was plagued by excessive compensation, but that compensation tied to performance was somehow more fair and appropriate than that which wasn’t. Section 162(m) created a powerful incentive for firms that wanted to retain top talent to offer compensation conditional on results in any given year. This, in turn, may have exacerbated the tendency to focus on short-term rather than long-term outcomes.
Our amnesia about well-intentioned regulations like section 162(m) is part of a larger pattern. Idealistic Clinton administration officials, like idealistic officials stretching back decades, wanted to take on excessive CEO compensation because they saw it as dangerous and an affront to their sense of fairness. What they didn’t realize is that this seemingly minor tweak to the incentives facing private firms would have unintended consequences that risked spiraling out of control.
Section 162(m) pales in significance against the much larger impact of federal deposit insurance, which was first established during the New Deal era as a temporary measure to protect a handful of small local banks. To his great credit, President Franklin Roosevelt opposed deposit insurance, having seen its perverse consequences at the state level. In theory, the point of deposit insurance is to spare small savers the need to weigh the riskiness of the assets held by local savings banks. But postal savings accounts, invested in ultra-safe government debt securities, would do a far better job of protecting the assets of small savers. The actual political driver behind deposit insurance was the desire of small, undiversified banks that were vulnerable to shocks to compete more effectively against big, diversified banks that were much less so. In the absence of deposit insurance, banks had a strong incentive to avoid excessive risk-taking, as few depositors were willing to gamble with their life savings.
In the decades since, deposit insurance has grown without limit. Though technically deposits are only protected up to $250,000, the effective limit is much higher than that due to the increasing use of the Certificate of Deposit Account Registry Service, or CDARS, a financial product devised by Princeton economist and Clinton White House veteran Alan Blinder. Essentially, CDARS breaks up multimillion-dollar investments from high-net-worth individuals into bite-sized accounts protected by federal deposit insurance. So now even sophisticated investors — the kind who have the resources and the know-how to make informed decisions about which banks are safest — have no incentive to choose their bank on the basis of safety. And so the U.S. financial system grows riskier and riskier with each passing year, and crashes grow ever more frequent and devastating.
As we’ve debated the future of the financial system, a small number of public intellectuals have called for rethinking deposit insurance. Raghuram Rajan, a professor at the University of Chicago’s Booth School of Business, is a notable example, as is Charles Calomiris of Columbia Business School. But so far, the idea has gained no political traction. Instead, we layer new bad regulations on top of old bad regulations and call it progress.
What’s galling about this isn’t so much the contrast between a flourishing Wall Street and a floundering Main Street, though that certainly rankles. It is the fact that the U.S. financial system seems no more stable today than it did before the 2008 financial meltdown. Indeed, many fear that the cascading debt crisis in Europe will be enough to bring down financial institutions on both sides of the Atlantic, causing still more economic hardship.
Anger at Wall Street is in a very real way undermining the legitimacy of the market economy. Voters are clamoring for a stronger regulatory response. The latest NBC News/Wall Street Journal poll found that 74 percent of respondents believe that the Obama administration hasn’t done enough to reform the financial system. Despite these overwhelming numbers, the main Republican presidential candidates are maintaining, to their peril, that repealing Dodd-Frank is the most important thing Congress can do.
But the rot in our financial system didn’t start with Dodd-Frank.
Recently, Nassim Nicholas Taleb, author of “The Black Swan” and a much-admired financial guru, called for banning bonuses at too-big-to-fail banks. His argument is that performance-based compensation encourages bankers to make risky bets, which may well be true.
We would do well to keep in mind a cautionary example. During the 1990s, section 162(m) of the tax code ended the tax deductibility of cash compensation above $1 million to CEOs and other top executives unless that compensation is performance-based. The idea behind this provision was that Corporate America was plagued by excessive compensation, but that compensation tied to performance was somehow more fair and appropriate than that which wasn’t. Section 162(m) created a powerful incentive for firms that wanted to retain top talent to offer compensation conditional on results in any given year. This, in turn, may have exacerbated the tendency to focus on short-term rather than long-term outcomes.
Our amnesia about well-intentioned regulations like section 162(m) is part of a larger pattern. Idealistic Clinton administration officials, like idealistic officials stretching back decades, wanted to take on excessive CEO compensation because they saw it as dangerous and an affront to their sense of fairness. What they didn’t realize is that this seemingly minor tweak to the incentives facing private firms would have unintended consequences that risked spiraling out of control.
Section 162(m) pales in significance against the much larger impact of federal deposit insurance, which was first established during the New Deal era as a temporary measure to protect a handful of small local banks. To his great credit, President Franklin Roosevelt opposed deposit insurance, having seen its perverse consequences at the state level. In theory, the point of deposit insurance is to spare small savers the need to weigh the riskiness of the assets held by local savings banks. But postal savings accounts, invested in ultra-safe government debt securities, would do a far better job of protecting the assets of small savers. The actual political driver behind deposit insurance was the desire of small, undiversified banks that were vulnerable to shocks to compete more effectively against big, diversified banks that were much less so. In the absence of deposit insurance, banks had a strong incentive to avoid excessive risk-taking, as few depositors were willing to gamble with their life savings.
In the decades since, deposit insurance has grown without limit. Though technically deposits are only protected up to $250,000, the effective limit is much higher than that due to the increasing use of the Certificate of Deposit Account Registry Service, or CDARS, a financial product devised by Princeton economist and Clinton White House veteran Alan Blinder. Essentially, CDARS breaks up multimillion-dollar investments from high-net-worth individuals into bite-sized accounts protected by federal deposit insurance. So now even sophisticated investors — the kind who have the resources and the know-how to make informed decisions about which banks are safest — have no incentive to choose their bank on the basis of safety. And so the U.S. financial system grows riskier and riskier with each passing year, and crashes grow ever more frequent and devastating.
As we’ve debated the future of the financial system, a small number of public intellectuals have called for rethinking deposit insurance. Raghuram Rajan, a professor at the University of Chicago’s Booth School of Business, is a notable example, as is Charles Calomiris of Columbia Business School. But so far, the idea has gained no political traction. Instead, we layer new bad regulations on top of old bad regulations and call it progress.
