Sunday, September 15, 2013

How To Stop the Too Big From Failing

Congress, and financial regulators in America and other nations, have struggled endlessly with the problem of financial institutions too big to fail.  Capital requirements have been increased, and regulation has been tightened (somewhat--much of the implementation of the Dodd Frank Act remains unfinished).  But the problem remains.

There is a simple way to seriously reduce the possibility of another taxpayer-funded bailout.  If a financial institution needs a government bailout, force the CEO, COO and CFO, and the members of the Board of Directors, to pay to the government the value of their entire compensation for the preceding five years.  This would include salary, bonuses, stock options, restricted stock, fees, country club memberships, company cars, and all other perks and compensation.  This payment would be required without regard to whether or not the executive officer or director was proven to have participated in any wrongdoing or neglect.  It wouldn't be a penalty for misconduct.  It would be an incentive to avoid sticking the government with the costs of mismanagement.

Any such proposal would, of course, provoke howls of outrage from financial institutions and their free-roaming packs of mouth-foaming running dog lobbyists.  Such a measure would be unfair if the officer or director hadn't been shown to have engaged in misconduct, it would be argued.  However, the SEC already has the legal authority to force a company's CEO and CFO to pay out all their compensation for the 12 months following the issuance of financial statements that are subsequently modified (in a form called a restatement)--see Section 304 of the Sarbanes-Oxley Act.  The SEC isn't required to show that the CEO and CFO did bad things.  They can be forced to make this payout simply because the original financial statements were wrong and needed to be restated.  The courts have upheld this authority.  There's nothing unfair about requiring senior executives to get important things right in the first instance.

Banks and other financial institutions might also object that they couldn't recruit the executive talent they need if this financial Sword of Damocles were to hang over their heads.  But, when we consider the geniuses at some financial institutions in the recent past who steered their firms right over cliffs and into government safety nets, this argument loses its persuasiveness.  Executive compensation arrangements at the too big to fail seem to incentivize risk-taking, even if it might entail unmanageable complexity.  There needs to be a disincentive--and a strong one.

The government has been criticized for not penalizing the high and mighty for the financial crisis of 2008.  Remember, however, that the statutes and regulations governing financial institutions are complex.  Proof of violations can be difficult.  A simple measure like a penalty of five year's compensation for a government bailout offers a way to nail the top dogs for signing a chit the taxpayers have to pay.

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