Reader B.K. writes to suggest I have a look at an article in The New Republic, "The Next Financial Crisis," by Peter Boone and Simon Johnson. The reader writes, "A key issue addressed, as I interpret it, is whether higher capital requirements or sufficient skin-in-the-game by private parties and private institutions might enable our country to steer a virtuous mean between the twin vices of predatory capitalism and regulatory collectivism, thus preventing cost shifting and fostering responsible stewardship. Without this reform one wonders whether any amount of regulation could serve as a substitute, whereas with the reform a vast number of regulations might prove unnecessary and avoidable. From this would hopefully flow an improved competitive position, greater humanity and a spreading of the blessings of freedom."
The reader's summary of the article is correct. Mr. Boone and Mr. Johnson are critical of the rescue the Wall Street Journal has been touting as a success. They write: "Consider the lessons learned in the past twelve months by our major banks. If they again get into serious financial trouble, the Fed can be counted on to lend them essentially unlimited amounts at effectively zero interest rates."
And the New Republic writers do focus on the "skin-in-the game" issue. They write, "Over the past century, we have moved away from a system where bank shareholders and senior executives paid dearly for bad management--and toward a system where fired bank bosses make off with fortunes or launch brilliant political careers. No one is on the financial hook, other than the taxpayer." They offer the example of Citigroup, where "Chuck Prince, the CEO who fell flat on his face, walked away with close to $100 million. Win Bischoff, former chairman and interim CEO of Citigroup during the debacle, has just been appointed chairman of Lloyds Banking Group in the United Kingdom--reflecting the high esteem in which he is apparently still held. And Robert Rubin, Treasury secretary under Clinton, made over $100 million as board member and chair of Citigroup. In an interview late in 2008, he brushed off any responsibility for the mismanagement of anything."
Mr. Boone and Mr. Johnson conclude: "the managers and boards of directors of financial institutions should be personally liable up to a reasonable sum when their companies fail. They should lose a portion of past salaries and bonuses, while also seeing their bank-provided pensions reduced substantially. Richard Parsons, the chair of Citigroup since February 2009, is estimated to be worth more than $100 million. Yet he reports that he owns only around $750,000 of Citi stock. Such negligible personal downside risk for the board of directors is the norm in high finance today. We should let bank executives be paid well when they are successful--but they should truly lose if they take risks that lead to taxpayer bailouts. It can take up to a decade before the success or failure of past business decisions really becomes evident in banking, so reductions in pensions, and clawback of bonuses, should take this into account."
There are two separate but related issues here. First, whether there is a "skin-in-the-game" problem, and second, how it should be rectified and by whom.
In respect of the first, it's not at all clear that having management with more personal downside risk would have prevented the financial crisis or diminished risk-taking by firms. Mr. Boone and Mr. Johnson offer the example of Citigroup, but they ignore the case of Bear Stearns, whose chief executive, Jimmy Cayne, saw the value of his stake plummet to $61 million from $1 billion. The New York Times reports that the chief executive of Lehman Brothers, Richard Fuld, "was once worth close to $1 billion and now has a net worth estimated at about $100 million." One could argue that any system in which those who failed as spectacularly as did Messrs. Fuld and Cayne still walk away with tens of millions of dollars is still one that imposes insufficient downside risk. But with all due respect to Messrs. Boone and Mr. Johnson and to reader B.K., it disregards the facts to argue that the big problem with Lehman and Bear Stearns was that management had insufficient skin in the game.
Suppose you don't buy the argument just made here about Cayne and Fuld, and suppose that you'd still feel more comfortable if Citigroup chairman Parsons held $1 billion in Citigroup stock in the way that Cayne and Fuld held $1 billion apiece in Bear and Lehman stock. That raises the second question: should the policy be dictated by government regulators, or should it be set by shareholders? If Mr. Boone and Mr. Johnson think financial companies in which managers are compensated in stock that they must hold over long periods of time will perform better than those with other compensation arrangements, they are free to invest their own money in banks that operate under those principles, and to refrain from investing their money in banks that disregard those principles. If "a lot of management skin in the game" turns out to be a compensation principle that correlates highly with business performance, the investment decision of Mr. Boone and Mr. Johnson will eventually be rewarded by the market. If, on the other hand, the government is going to go around using taxpayer funds to rescue banks that perform poorly, then there starts to be an argument for imposing more regulations. Banks might be offered a choice: you can set your own compensation arrangements if you agree to foreswear any future taxpayer rescues, but if you want to be eligible for such rescues, then you have to set up your compensation policy (and, for that matter, your capitalization) in the way that the government dictates.