Monday, March 16, 2009

WSJ: Bankers Need More Skin in the Game

Of all the causes of the financial meltdown of the past few years, the easiest to understand is that an irresponsible attitude toward risk led to terrible mistakes in judgment. But where did this casual approach to risk originate?

A major culprit, we believe, is a change in the way Wall Street financial institutions are organized. During the late 1970s and '80s, much of the responsibility for risk was transferred away from the people who made the financial decisions. As a result, leverage rose from 20-1 to 40-1 or higher, creating shaky towers of debt, which, as we know, eventually collapsed.

Of course, risk is not a bad thing. John Maynard Keynes identified the importance of "animal spirits," the naive optimism of entrepreneurs, to a robust economy: "The thought of ultimate loss which often overtakes pioneers . . . is put aside as a healthy man puts aside the expectation of death."

The trick is to find a way to encourage sensible risk-taking, while dampening the impulse to take chances that can throw an economy into recession and force taxpayers to bail out a banking system.

Can government accomplish this feat through rule-making and regulatory oversight? It is unlikely. As the Nobel Prize-winning economist Friedrich von Hayek correctly emphasized, no one -- not even a politician or a bureaucrat -- can gain the broad and deep knowledge necessary to make wise enough rules. Moreover, in a $14 trillion economy, you can't hire enough overseers to pore over everyone's books.

There is, however, a better solution: expose players in the financial game to greater personal loss if their risk-taking fails. When you worry that a mistake will cause you to lose your second home, your stocks and bonds and your club memberships, then you're less likely to take the kinds of risks that expose the rest of society to your failures.

A simple mechanism exists to achieve this purpose: the private partnership. Partners face liability that extends to their personal assets. They aren't protected by the corporate shield that limits losses to what the corporation itself owns (as well as the value of the stocks and bonds the corporation has issued). Unfortunately, the partnership is a legal form of business organization that was largely abandoned by banks over the past quarter-century. Our advice is to bring it back. In other words, don't nationalize; partnerize.

We know from Alfred Chandler, the great business historian, that "strategy determines structure." Similarly, structure determines behavior -- in this case, a healthier attitude toward risk. It is unlikely that a partnership will grow to the size of a Bank of America or Citigroup, but, while size can boost efficiency, it also poses systemic risk. As partnerships -- and corporations with partnership attributes -- replace behemoths, the current crisis will spawn structures for future success.