Column The wall crumbles

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: markets panic and rating agencies downgrade the debt of leading firms, making it harder for them to raise money. Obviously, shareholders of collapsing firms lose heavily—a nationalisation pays shareholders a pittance (Fannie and Freddie), a bankruptcy pays nothing (Lehman) and an emergency buyout gets them a much reduced price on their shares (Merrill). This includes CEOs, who lose heavily on stock options even though they do walk away with comfortable severance packages worth millions of dollars. It’s a vicious cycle to the bitter end.

The focus at the moment is obviously on finding a cure to stem any further collapses of institutions, and to prevent a complete collapse of the US financial system, which will have ripple effects into Europe and Asia. So, all the discussion and debate around nationalisation, buyouts, emergency funding and the like is obvious. However, in the longer term, the focus must shift to prevention—given the importance of any financial system to the economy as a whole, prevention is clearly better than the cure.

Any preventive strategy or policy must reduce the amount of excess risk that was being taken in the US financial system. The incentives of shareholders, employees and senior management seem bent towards extracting maximum short term profits, which require taking risk beyond what would normally be considered prudent or acceptable. Also, the expectation that a bailout will come if things turn sour creates a severe moral hazard problem. The strategy of lending to high-risk borrowers with patchy credit histories—but who pay higher interest rates (subprime borrowers)—was one such high risk strategy which yielded high returns when the housing market was booming, but quickly turned sour once the housing market collapsed. Banks have already lost some $300 billion on subprime mortgages.

There now needs to be a rethink on corporate pay with a greater emphasis on performance over longer time horizons, which enables a sharing of losses and profit—perhaps bonuses should be distributed over say a five year period; or at the time of leaving a firm; anything that would make managers turn away from an exclusively short term, maximum profit, excessive risk taking way of functioning. Stephen Green, Chairman of HSBC, unusually for an insider, supported such a change in an interview to the BBC over the weekend.