CAMBRIDGE – Since the global financial crisis, regulators have worked hard to make the world’s big banks safer. The fundamental problem is well known: major banks have significant incentives to take on excessive risk. If their risky bets pay off, their stockholders benefit considerably, as do the banks’ CEOs and senior managers, who are heavily compensated in bank stock. If they do not pay off and the bank fails, the government will probably pick up the tab.
This confluence of economic incentives to take on risk makes bank managers poor guardians of financial safety. They surely do not want their bank to fail; but, if the potential upside is large enough, it is a risk they may find worth taking.
Several solutions to this problem have been proposed, and some – such as increased capital requirements and restrictions on risky investments – are headed toward implementation. More recently, two other important solutions have emerged.
Under the first, more developed proposal, banks would undertake large obligations via long-term bonds, which would be paid only if their operations are sound. In effect, the long-term bondholders would guarantee the rest of a bank’s debts, including the riskiest ones. If the bank faltered, the guaranteeing bondholders would stabilize the most troubled elements of the firm. The bondholders – not the bank’s core operations – would take the hit.