How to Beat Wall Street at Its Own Game

Last Updated Dec 7, 2009 1:41 PM EST

Two University of Minnesota law professors have a neat -- and commonsensical -- way to treat Wall Street for its gambling addiction: Make bankers personally liable for losses.

In a farsighted new paper, Claire Hill and Richard Painter propose that bankers earning over $3 million per year be required to work under a joint venture or partnership arrangement with their firm. That means if the bank loses money, they lose money.

Another idea is that any compensation exceeding $1 million in a given year be paid in "assessable" stock. These are shares that a company can issue at one price, but later ask the holders for more money to reflect changes in the stock's value. In other words, a banker who's given stock at no cost or a steep discount as part of his comp would have to buy the shares at a higher price if the company eventually goes bankrupt.

Say the profs:
The public bears the brunt of the cost from excessive risk-taking by banks, but government regulation thus far has been inadequate to protect the public interest. Some form of personal liability for bankers is, we believe, something to consider: it may be a very effective way of reducing the risk taking that imposes such enormous cost on the public.
These approaches recognize a key, but often overlooked, factor in the debate over escalating Wall Street bonuses: How much bankers make matters less than how they're paid. They also get at the heart of the problem, which is that top bankers are rewarded for taking large risks. Typically, the bigger the risk, the bigger the reward. Almost by definition, the most successful bankers are the ones willing to lay it all on the line, because that's how you get ahead at, say, Goldman Sachs or Citigroup.

But what about paying bankers with long-term stock, rather than bonuses or stock options? In theory that should hitch their financial fortunes to that of the company's.

Except it doesn't. Leaders at Lehman Brothers had enormous equity stakes in the company. Yet they still rolled the dice. Why they did is a complicated question, and requires considerably more space than we can give it here.

But one major reason is that investment banks largely play with other people's money. If someone sends you off to the casino with a wad of cash, you're more likely to let it ride than if you're gambling with your own dough. The rules of behavioral finance also suggest that folks are more likely to double down if they're on a winning streak. Wall Street, which places the casino within the safe confines of limited liability, functions in much the same way.
This same risk-prone banker, however, might have a very different attitude if faced with the prospect of having very little in the way of personal assets left over because he took a bad risk.
The best part of Hill's and Painter's solution is that it's been tried before. For, oh, the better part of a century. As they recount, until the 1980s most investment banks were general partnerships. Partners shared not only in the upside, but also the downside. If the bank croaked, their wealth died with it.

Things started to change in the 1970s. The New York Stock Exchange began allowing brokerage firms to have a public float. Companies argued that in order to raise outside capital, shareholders needed protection from unlimited liability. Over the next couple decades, investment banks ditched their partnerships to become LLCs. The last holdout, Goldman, finally converted in 1999.

That also was the year Congress broke down the wall between investment and commercial banking. As these cultures merged, the ethos and imperatives of Wall Street took over. And so did the way investment bankers were paid. Risk, which once was their concern, largely became someone else's problem.
  • Alain Sherter On Twitter»

    Alain Sherter is an award-winning business journalist who has written for The Deal, MarketWatch and Thomson Financial Media.

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