Here’s one reason why the issue of big bonuses at bailed-out firms has come up at all: “moral hazard.”
Moral hazard? It’s a venerable term in finance describing the problem that arises when key decision makers are insulated from the impact of their decisions. But, instead of a detailed definition of the phrase, here’s an example of how moral hazard might affect you:
Invest all your money in, say, cold fusion technology. Big gamble, but it if it works, you make a fortune! If it fails, you still win. The government bails you out, declaring that you are too big to fail. Now, pay yourself a big executive bonus as a reward.
Ah, if only the real world worked that way for you and me! It works for big financial institutions but not for us.
With the U.S. government as the Big Insurer, bankers have huge incentives to make extremely risky investments. They might win big. But if they get into trouble, the feds bail them out—and then they pay themselves big bonuses.
This week, legislation was proposed that would end the moral hazard problem. The idea is that, with this new legislation: When a big firm gets in trouble, the executives would be sacked and the shareholders would shoulder the financial loss.
U.S. Treasury Secretary Timothy F. Geithner explained: “Under the proposed special resolution authority, a failing firm would be placed into an FDIC-managed receivership. The purpose of the receivership would be to unwind, dismantle, sell, or liquidate the firm in an orderly way that protects the financial system at lowest cost to taxpayers. Shareholders and other providers of regulatory capital of the failing firm would be forced to absorb losses, and managers responsible for the failure would be replaced.”
This legislation would produce “strong, accountable supervision of all our major financial firms and imposes costs not on the taxpayer but with the risk-takers, where they belong. It deters excessive risk taking and forces firms to better protect themselves against failure.” (You can read more on the U.S. Treasury Web site.)
What do you think of this proposed measure? Do you support it?
Would it really solve the problem?
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