Why Banking Regulation is Inevitable

Jim Fink, senior online editor for Investing Daily, is a self-confessed free market champion. But he nevertheless believes financial reform is both inevitable – and deserved. The reason? Something he calls the “Agency Problem” in investment banking.

Shareholders own a corporation, he says, but they hire agent-managers (executives) to run the business for them. In a perfect free-market world, the agent’s interests would be neatly aligned with that of the shareholders. But in reality, these financial interests can diverge widely, as we’ve seen in the recent financial meltdown.

Investment banking executives, for example, were the ones in charge of the firms securitizing subprime mortgages and credit default swaps and selling these toxic investments to institutions. The trouble is, the compensation scheme for the “agents” or executives doing the selling didn’t gibe with the risk of loss if the securities on the bank’s balance sheet became worthless, he says.

Executives had virtually unlimited upside, and very limited downside (getting fired). Hence, after a few multi-million dollar years, they were set for life. If the whole scheme blew up and wrecked their firms, they would be long gone.

Back when investment banking firms were partnerships, it’s highly unlikely that top executives would put this much of their personal wealth at risk. But once they became public-owned companies, it was the shareholders who were left holding the bag.

Fink makes an interesting comparison to this type of behavior and the definition of a psychopath. Psychopaths are people who “fail to feel remorse or guilt … appear to lack a conscience and are completely self-serving. They routinely disregard rules, social mores and laws, unmindful of putting others at risk.”

His conclusion? The psychopaths in investment banking cannot be trusted any longer. And that’s why investment banking reform is inevitable, and even supported by people like him who would otherwise be diametrically opposed to more regulation.

It’s worth reading the whole article at Investing Daily Online. In the meantime, what do you think? Is it the nature of the investment banking business to focus on self-interest? Must bankers be bludgeoned back into being more responsible? Add your comments below.

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{ 1 comment }

Zane April 3, 2010 at 3:54 am

Changes should be considered in terms of the regulatory model and its components, existing human expertise, the legal infrastructure, government goals and starting economic resources. All agree that while more and more dense regulation is now inevitable, they doubt it will really change the essentials.

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