Govt. to Banks: With each passing moment you make yourself more my servant!

The idea of the government mandating pay packages is stomach churning. It has nothing to do with the relative wisdom of any given compensation scheme. I completely agree with the idea that the way bonuses were structured in a lot of cases created an incentive for employees to shoot for the moon. If you tell me I might make $5 million in a single year, and the only way I can make that money is by putting on very risky trades (with the bank's money), what am I likely to do? If I lose I might get fired but I can always find another job. If I win, I get $5 million to put in the bank. The next year I will try the same risky trades and if they don't work next year guess what? I still have my $5 million!

But even if the idea of more sensible compensation packages is a good one, we all know the government is going to muck it up. Let's say that in 2010, regulators come up with a very reasonable and logical set of pay rules, which allow those that really do perform to become insanely wealthy while being properly incented to maintain reasonable risk levels. But what happens in 2011 when there is a new congress? Or in 2013 when there is a new President? Will the standard of "reasonable risk" and "reasonable compensation" be a moving target? You bet your light sabre that it will.

All that being said, let me throw out a different spin on all this talk about compensation limits. Now stay on target with this, because I'm going to make a pretty wide arc here to get to my final destination.

The other day I wrote about Too Big To Fail. I argue that the way to solve Too Big To Fail is not to mandate that banks take less risk. There is no way to build regulations today that will imagine all the possible ways banks might take risk in the future. Remember that the current bank regulations were designed to curb risks by forcing banks to put more capital up against riskier assets. The problem was that "risky" was defined by credit rating. So why did banks buy up every Super Senior CDO they could find? Because it was AAA-rated! They could pledge minimal capital! (or none if they set it up as a SIV!!!)

I therefore warn against future attempts to reduce bank's risk through regulation. Eventually banks will figure a way around the regulation and get as risky as they want to be anyway.

As I said the other day, the key isn't to make banks less risky, but to make the banking system less risky. I don't want to see us regulate away risk and at the same time regulate away financial innovation. In fact, I'd love to see a competitive market for banking, where some banks choose to take more risk and some choose to take less and we see who ultimately prevails. Wouldn't we rather live in a world where creative and successful risk taking is rewarded? If the government dictates risk, then it will be those that are creative at getting around the rules who are rewarded.

The only way such a system can exist is if no one bank, or even not a group of banks, pose a substantial systemic risk. This is the opposite of what we have now, banks that are so interconnected that the failure of Lehman Brothers almost touches off a Great Depression. I mentioned some remedies the other day, such as creating a central counter-party for over-the-counter derivatives.

But part of the solution has to be to make banks smaller. In order to create such a system, there has to be an incentive for banks to remain smaller. Currently there is an incentive to get bigger. Bigger banks like J.P. Morgan or Wells Fargo can brag about their earnings/geographic diversity and thus access the capital market cheaper. Some argue that banks have a direct incentive to get bigger in order to reach Too Big To Fail status! I don't know that bank managers think along these lines, but its clear that bond investors feel this way. Why else would a moribund bank like Citigroup have easier access to capital than a more conservative bank like M&T Bank? We all know Citi is (or at least was) functionally insolvent. Only their Too Big To Fail size saves them.

Alternatively, what if we actually created an incentive for banks to remain smaller? For example, say there was a government backstop for prime brokerage accounts, similar to what I described the other day. But let's say it was structured like the FDIC insurance on deposit accounts, where PB accounts above a certain size enjoy no guarantee. Hedge funds would have to diversify their holdings across many prime brokers creating a natural limit on how large any one prime broker could get, at least in terms of using PB as a funding vehicle.

When Lehman failed, many fund assets became tied up in bankruptcy. Many more were withdrawn from other firms (Goldman, Morgan Stanley) for fear that they could face the same fate. It becomes a all risk, no reward situation. If I keep my money at Morgan Stanley and they survive, I get no reward. If they fail, I wind up with my account frozen. So every one withdraws. According to various sources, Morgan Stanley lost 1/3 of their prime brokerage accounts in the week following Lehman's failure. That alone might have been enough to sink Morgan Stanley if it hadn't been for Fed liquidity programs. So even if Morgan Stanley had been a innocent by-stander, they might have failed on contagion alone.

As tax payers who wind up on the hook for the failure of these firms, we have to see how this is entirely untenable. We can't have a world were Firm A pays for the sins of Firm B. Even if Firm A isn't entirely innocent, its still an idiotic policy to even make such a situation remotely possible.

If there were some insurance for prime brokerage, this wouldn't happen. Because of the government backing, no given investment fund would have to panic about the financial condition of any one of their trading partners as long as they were adequately diverse in their prime brokerage relationships. Meanwhile if a PB failed, the contagion ramifications would be limited.

This is exactly why we have FDIC insurance, by the way. So that when First National Bank of Alderaan fails (due to no remaining customers!) customers of First National Bank of Tatooine don't panic.

Anyway, its just one idea. The point here is that we need to make more progress on this Too Big to Fail problem. I advocate a two-pronged approach. Limit the contagion, and create incentives for banks to remain smaller.

So now we're back to compensation. I told you it would take a while. Anyway, what if compensation was only restricted once a financial institution reached a certain size? We'd make it any financial firm, from investment manager to bank to insurance company. If you want to make the big bucks, go to a non-TBTF bank!

Anyway, that's not something I'd actually advocate if I were Libertarian Dictator of the World. I'd probably mandate no restrictions at all. If anything I'd give voting shareholders an easier way of mandating a better compensation scheme. But compared to what the government is actually going to do, I think this idea is a pretty good one.