Using the law to reduce systemic risk.

• Author: Sharfman, Bernard S.

1. Introduction II. Systemic Risk and Public Policy III. Managing Systemic Risk A. Internalizing Systemic Risk B. Reducing Systemic Risk Through Regulation C. Finding the Right Balance in Regulating Systemic Risk IV. Wall Street's Front-Loaded Bonus Culture A. The Problems with Front-Loaded Bonus Compensation B. The Fat Tail C. The AIG Example V. The Persistence of Wall Street's Front-Loaded Bonus Culture VI. The Role of Executive Management in Controlling Their Employees' Short-Term Focus VII. Managing Systemic Risk Through the Manipulation of Bonus Compensation Plans A. The European Union Approach B. Alternative Academic Proposals 1. Bebchuk and Spamann 2. Tung 3. Bhagat and Romano C. A Tax Policy Approach D. The Heart of the Proposal E. Supplemental Requirements VIII. Conclusion The recent financial crisis has put into focus how financial innovation can lead to the implementation of financial sector business models that are potentially unsustainable. While these business models are not necessarily bad if there is no viable alternative, policy makers and regulators need to make sure the financial sector is not overinvesting in such models as they may create unnecessary nodes of systemic risk.

   To minimize overinvestment, policy makers and regulators must focus on and regulate practices that encourage financial sector participants to be indifferent to the use of unsustainable business models. one possible practice originates from the large, frontloaded bonus arrangements provided to Wall Street employees (traders, investment bankers, and asset managers). These arrangements provide incentives for employees to focus on maximizing their personal short-term returns at the expense of their employers' and society's long-term interests.

   For a solution to the problems created by these compensation arrangements, this Article recommends limiting the tax deductibility of financial sector compensation at the entity level, a new tax similar to Internal Revenue Code section 162(m), but with a much greater reach as it would apply to all Wall Street employees who work for financial sector firms. This new law would be supplemented by a provision that would restrict payouts of current and deferred bonuses at those times when a firm's performance measures indicate excessive firm-specific risk.

1. INTRODUCTION

   The recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act or Act) (1) will have a major impact on how the financial sector operates. For example, it proposes to change dramatically the way derivatives (2) are regulated, cleared, and traded by requiring that the majority of trading and clearing of derivatives be moved from the opaqueness of over-the-counter markets into the light of regulated clearinghouses and exchanges. (3) Moreover, the Dodd-Frank Act will also prohibit banking entities from engaging in the "proprietary trading" of financial instruments unrelated to customer-driven business. (4) Surely, these and other provisions found in the Act will help reduce the financial sector's proclivity for creating systemic risk.

   However, the approach taken in the Dodd-Frank Act to reduce the financial sector's systemic risk is incomplete. The problem is that it is backward-looking. The Act does not take into consideration that--if history is any guide--financial innovation will lead to the development of new financial sector business models that are potentially unsustainable. unfortunately, it is unpredictable which models they will be and whether they will reach the level of implementation such that new critical nodes of systemic risk will be created and possibly realized.

   There are several notable examples of the financial sector developing and creating unsustainable business models. Prior to the 1930s, our banking system was susceptible to runs until federally sponsored deposit insurance was implemented; (5) in the early 1980s, savings and loan institutions and Fannie Mae--a government sponsored enterprise set up to create a secondary market in residential mortgage loans--suffered large losses because of a business model that relied heavily for its success on interest rates forming an upward sloping yield curve; (6) in 1998, the near collapse of Long-Term Capital Management (LTcM) resulted from a business model that did not anticipate the negative effects on its investments from the sudden and violent movements in bond prices, the overreliance on financial leverage, and on the use of financial models that underestimated the probability of rare events; (7) and in 2008, American International Group, Inc. (AIG) and other market participants such as Lehman Brothers Holdings Inc.; Merrill Lynch & Co., Inc.; Bear Stearns Companies, Inc.; American Home Mortgage Investment Corporation; Independent National Mortgage Corporation (IndyMac); Thornburg Mortgage Inc.; and New Century Financial Corporation--being, as it turns out, overly dependent on the shadow banking sector (8) for their short-term funding--fell victim to the sudden illiquidity of securities backed by residential mortgage loans. (9)

   Yet, it is not necessarily a bad thing that the financial sector utilizes unsustainable business models. For example, prior to the rise of residential mortgage loan securitization, (10) borrowing short and hoping that the yield curve would not invert was really the only way that financial institutions could provide the long-term fixed rate mortgage loans that borrowers desired. Moreover, this was a very workable strategy for many years up until the early 1980s. (11)

   In essence, the financial sector's use of unsustainable business models creates risk at all levels, including firm-specific, sector and systemic. It is the price we pay for allowing the financial sector to find innovative ways to allocate our investment capital in a world of incomplete financial markets. (12) The economy relies on this sector to make the necessary investments in time, resources, and research in order to efficiently decide where our scarce investment capital should go. (13) For the financial sector to fulfill its vital mission in our economy, an unfortunate byproduct is systemic risk.

   Therefore, a supplement to the approach taken in the Dodd-Frank Act is required. Regulators need to make sure the financial sector is not overinvesting in unsustainable business models that may ultimately lead to unnecessary nodes of systemic risk. To accomplish this task, policy makers and regulators must focus on and regulate those practices that encourage financial sector participants to be indifferent to the use of unsustainable business models. one possible practice originates from the large, frontloaded bonus arrangements provided Wall Street employees. (14) These arrangements, the focus of this Article, provide incentives for employees to focus on maximizing their personal short-term returns at the expense of their employers' long-term interests. (15)

   The goal in solving this indifference problem is to lengthen the period of time over which Wall Street employees are able to cash in on their bonus compensation and thereby more closely align the interests of Wall Street employees with their employers. Moreover, from an efficiency perspective, it would be most preferable to have the market place do this without government intervention. However, as argued in Part V of this Article, the strong negotiating position of Wall Street employees makes it difficult to implement changes in bonus compensation arrangements and as argued in Part VI, the executive management of financial sector firms are both limited and conflicted in their ability to align the interests of their employees with their firms. Therefore, the federal government, with its interest in managing systemic risk, must step into the compensation arena and help make sure that there is a proper alignment of interests.

   To efficiently lengthen out the period of time over which Wall Street employees receive their bonus compensation, this Article recommends changes to the current federal tax laws, supplemented by the use of powers that policy makers and regulators already have under current law, namely section 956(b) of the Dodd-Frank Act. More specifically, this Article recommends limiting the tax deductibility of financial sector compensation at the entity level, similar to Internal Revenue Code section 162(m), but with a much greater reach as it would apply to all Wall Street employees who work for financial sector firms and it would also not allow for performance based exceptions to the deductibility limit. This new law would be supplemented by a provision that would restrict payouts of current and deferred bonuses at those times when a firm's performance measures indicate excessive firm-specific risk.

   Part II begins the discussion by defining systemic risk and explaining how it interacts with public policy. Part III describes the issues involved in managing systemic risk. Part IV describes the front-loaded bonus culture and the problems that it causes. Part V explains why the corporate governance of financial sector firms does not have the negotiating strength to change the front-loaded bonus culture without federal government support. Part VI explains why executive management cannot be expected to manage the short-term perspective of its employees. Part VII advocates the use of tax policy to cool the financial sector's front-loaded bonus culture. Part VIII provides a brief conclusion.

2. SYSTEMIC RISK AND PUBLIC POLICY

   In terms of systemic risk, the financial crisis of 2008 had aspects of the old and the new. In one respect, the collapse of the shadow banking system was similar to an old fashion bank run, but instead of having a run on bank deposits, there was a run on short-term debt. (16) The catalyst was the fall in housing prices. (17) When housing prices started to fall sharply, the value of subprime mortgage loans followed suit, soon to be followed by the value...