Using the Law to Reduce Systemic Risk

Abstract:     
The recently enacted Dodd-Frank Act will have a major impact on how the financial sector operates. For example, the Act will prohibit banking entities from engaging in the "proprietary trading” of financial instruments unrelated to customer-driven business. Surely, this 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 Act to reduce 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. 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 implement this approach, 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, front-loaded bonus arrangements provided Wall Street employees. These arrangements provide incentives for employees to focus on maximizing their personal short-term returns at the expense of their employers’ long-term interests.

For a solution to the problems created by these compensation arrangements, this essay 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.

Number of Pages in PDF File: 28

Keywords: Financial Institutions, Tax Policy, Systemic Risk, Compensation, Financial Regulation

JEL Classification: K22, K34

Accepted Paper Series