Financial Reform - "Put the Fear of God into Wall Street"
James Grant, editor of the oft quoted Grant’s Interest Rate Observer, has an idea to improve the financial reform proposal being considered by Congress. “Let the senior financiers keep their salaries and bonuses, and let them do with their banks what they will. If, however, their bank fails, let the bankers themselves fail. Let the value of their houses, cars, yachts, paintings, etc. be assigned to the firm's creditors….The plausible threat of personal bankruptcy would suffice to focus the minds of American financiers on safety and soundness as they have not been focused for years.” See “The best financial reform? Let the bankers fail,” by James Grant, Washington Post.
Noble aspirations like “for the good of the country” or “for the long-term good of the company’s shareholders” may motivate some CEOs, but nothing focuses the mind like fear. A dose of humility would also be helpful.
"The fear of God" was the secret of success for George Gilbert Williams, president of last century’s stodgy but super-safe Chemical Bank of New York. Nowadays, observes Grant, safety is nobody's concern except Washington's. One reason for that may be that CEOs and “Fabulous” Wall Street traders believe the secret of their success is their own ability and hard work. However, Lefty Gomez (New York Yankee pitcher, 1930-42), who once said that the secret of his success was a “clean living and fast outfield,” and who coined the line, “I’d rather be lucky than good,” knew their real secret.
“For rolling the dice, the payoff is potentially immense. For failure, the personal cost -- while regrettable -- is manageable,” says Grant. Thus senior executives at Lehman Brothers, Citi, AIG and Merrill Lynch lost their savings, but not the rest of their net worth.
In Brazil, which had to deal with the consequences of its own wild west financial markets, bank directors, senior bank officers and controlling bank stockholders are personally liable if their institutions become insolvent, says Grant. Their net worths are frozen for the duration of often-lengthy court proceedings, and ultimately, they can lose it all.
“The substitution of collective responsibility for individual responsibility is the fatal story line of modern American finance,” writes Grant. But, he points out, it has not always been like that. For 75 years, until the Federal Deposit Insurance Corp. was put in place, bank shareholders bore the cost of failure, just as they enjoyed the fruits of success. If the bank went broke, a court-appointed receiver went after their assets to compensate creditors, says Grant.
The system worked reasonably well, according to Grant and law professors who studied it. "The sums recovered from shareholders under the double-liability system significantly benefited depositors and other bank creditors, and undoubtedly did much to enhance public confidence in the banking system despite the fact that almost all bank deposits were uninsured," wrote Jonathan R. Macey, now of Yale Law School and its School of Management, and Geoffrey P. Miller, now of the New York University School of Law in a 1992 Wake Forest Law Review essay.
“Like one of those notorious exploding collateralized debt obligations, the American financial system is built as if to break down. The combination of socialized risk and privatized profit all but guarantees it,” concludes Grant. But this basic flaw in the system is not being addressed by the current reform proposals. “From the administration and from both sides of the congressional aisle come proposals to micromanage the business of lending, borrowing and market-making: new accounting rules (foolproof this time, they say), higher capital standards, more onerous taxes. If piling on new federal rules was the answer, we'd long ago have been in the promised land,” according to Grant.
Grant continues: “Until 1999, Goldman Sachs was a partnership, with the general partners bearing general and unlimited liability for the firm's debts. Today, Goldman -- like the vast majority of American financial institutions -- is a corporation. Its stockholders are liable only for what they invested, no more. And while there are plenty of sleepless nights, the constructive fear of financial oblivion is, for the senior executives, an all-too-distant nightmare.”
So, what should Congress be doing? Grant says: “The job before Congress is to bring the fear of God back to Wall Street. Not to stifle enterprise but quite the opposite: to restore real capitalism. By all means, let the bankers savor the sweets of their success. But let them, and their stockholders, pay dearly for their failures. Fair's fair.”
