Socialized Risk, Privatized Reward

William Cohan, in his New York Times blog makes the same connection I did in my blog entry "Time For a Progressive Leader" below, and in particular the destructive effects of the structure of corporations. No personal liability, no concerns: "The problem is that the corporate veil protects the decision makers from the consequences of their decisions and, accordingly, they are encouraged to take asymmetrical risks — huge paydays for them if everything works out; huge consequences for us if they don’t."

What these two disasters — one financial, the other environmental — prove beyond a shadow of a doubt is that the right incentives no longer exist to get corporate executives to do what they should want to do, and what they must do, to prevent such calamities from happening. The “corporation,” as a legal entity, is very good at attracting capital, providing jobs, maintaining a focus on profitability, creating wealth for the people who work there (especially at the top). It is also very good at shielding executives and boards of directors from liability for their poor own decision-making.

What these two crises reveal is that some corporations and their leaders aren’t very good at making decisions that take full account of the risks they and their companies are taking. It is a truism that human beings do what they are rewarded to do. But the corporate structure these days rewards bad behavior. The problem is that the corporate veil protects the decision makers from the consequences of their decisions and, accordingly, they are encouraged to take asymmetrical risks — huge paydays for them if everything works out; huge consequences for us if they don’t. As Senator Christopher Dodd correctly said in April 2008, during the first Senate hearing about the unfolding financial crisis, “We’ve socialized risk and we’ve privatized reward.”

Unfortunately, the financial reform legislation that Senator Dodd and his colleagues are working so hard on to make law does nothing to change that dynamic. Nowhere in the approximately 1,500 pages of the proposed bill is there anything about making Wall Street executives financially and legally liable for their decisions, as they once were when Wall Street was a series of private partnerships and a partner’s entire net worth was on the line every day. Talk about accountability! But that ethic was lost 40 years ago when Donaldson, Lufkin & Jenrette went public and the rest of Wall Street followed soon thereafter.

As a result, our financial crises come fast and furious these days, since Wall Street bankers and traders get rewarded for selling, and generating revenue, not for worrying about what they create. The time has come for actions to have consequences. You can be sure that if Jimmy Cayne, the former C.E.O. of Bear Stearns, or Dick Fuld, the former C.E.O. of Lehman Brothers, had their entire net-worth on the line every day instead of being able to gamble with the house’s money, they would have been much more focused on the risks their firms were taking.