Paul Krugman on the how the Obama Financial Reform Plan is Insufficient

He writes:

True, the proposed new Consumer Financial Protection Agency would help control abusive lending. And the proposal that lenders be required to hold on to 5 percent of their loans, rather than selling everything off to be repackaged, would provide some incentive to lend responsibly.

But 5 percent isn’t enough to deter much risky lending, given the huge rewards to financial executives who book short-term profits. So what should be done about those rewards?

Tellingly, the administration’s executive summary of its proposals highlights “compensation practices” as a key cause of the crisis, but then fails to say anything about addressing those practices. The long-form version says more, but what it says — “Federal regulators should issue standards and guidelines to better align executive compensation practices of financial firms with long-term shareholder value” — is a description of what should happen, rather than a plan to make it happen.

Two things:

First, one of the things that got investment banks in trouble is that they did hold on to part of the securities they created. Indeed, they held the riskiest stuff--the lowest rated tranches of subprime and commercial MBS. The reason: so long as they performed, they captured the margin between the rate on the underlying debt instrument and the rates paid to the higher tranches. They borrowed short term at low interest rates to invest in these high risk, high margin securities, and earned spectacular rates of return, for awhile.

Investment bankers had incentives to take risks, because while they were earning spectacular returns (IRRs), they got paid huge bonuses. But when their investments fell apart, they only lost their jobs--there was no claw back. While their companies failed, their total compensation for the time they worked remained high.

So, point two is that compensation schemes must align long-term company interests with pay. There are two ways to do this: through clawbacks (which are complicated) and through long-term restricted stock (which is how employees at Google get paid).

I should note, however, that I am very pleased with the administration's proposal for financial institution capital. That by itself will solve a lot of problems.