A Proposal For Reforming Wall Street

The fact that there is a culture of greed and excess on Wall Street is no secret. The blogger Cunning Realist wrote that in his experience, Wall Streeters are not exactly rocket scientists (and being a rocket scientist has its own problems) but focuses on how to be a BSD:

The culture rewards speed, opportunism, and quite often recklessness. It does not reward what most people consider “intelligence” — advanced mathematics ability, or knowing or caring about the difference between Shia and Sunni.

Efforts to rein in risk are not working because of the culture of revenue generation. A recent survey shows that risk managers are still second-class citizens at banks despite the onset of the financial crisis.

A case of misaligned incentives

The downfall of WaMu, Bear Stearns, Lehman and so on can be laid at the feet of the agency problem. If you work at a bank or broker, your compensation is tied to revenue generation and not risk control. It’s not your money!

Compensation payoffs on Wall Street, whether it’s at an investment bank or hedge fund, are asymmetric. If things go right, the investment banker, broker or hedge fund manager gets a disproportionate part of the upside and the investor gets a limited part. If things go wrong, the investor bears virtually all of the downside.

There is a really simple answer to all this. Bring back the partnership investment bank. Let Goldman Sachs (GS) and all the i-banks be partnerships again. That way, it’s the partners’ money again. If the partners want to lever the balance sheet up to 30-1 or 40-1, let them. If it doesn’t work, the partners get personally wiped out and some may have to declare personal bankruptcy. In the end, the return function becomes symmetric and the net aggregate effects will be positive. I don’t believe that partners of i-banks would collectively be willing to take those kinds of risks again, nor would they be willing to sacrifice long-term liability for short-term profits.

I would like to say that Rubin’s departure from Citigroup (C) marks the end of this era of greed, but until until the incentives are made symmetric and a large portion of future Bob Rubins’ personal wealth are tied up in the investment bank, nothing will change.

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