In any financial crisis, it is possible with 20/20 hindsight to
identify the specific proximal causes. Armed with this knowledge,
legislators are invariably tempted to outlaw specific activities. After
all, if these activities had been illegal prior to the crisis, surely
the crisis would have been avoided. The flaw with this seemingly
plausible logic is that it ignores the incentives that affect people’s
behavior. A better approach is to design legislation that better aligns
the incentives of bankers with the public interest.

Bankers are incentivized to make money. Inevitably, their actions
expose the economy to the kind of breakdown we saw in October. With new
regulations on their behavior, future crises will no doubt look
different, but they will not be eliminated. The only way to avert
crises is to treat banking in the same way we treat polluters: Create
an environment that internalizes the negative externalities banking
activity generates. That is, we should give bankers incentives so that
they do not want to engage in the kind of risk taking that exposes the whole economy to a meltdown.

To address this, we need to examine the effect of leverage. When
investors invest borrowed resources, a problem known to financial
economists as “asset substitution” is created: If the investment goes
bad, the investor can declare bankruptcy and leave the debt holders
bearing the costs. Because of this downside protection, risk takers
have an incentive to take on more risk than they would if there was no
leverage. Most debt holders are well aware of these incentives, and
ordinarily they monitor the behavior of the risk takers with policies
like margin requirements. By doing so, they avoid exposing themselves
to unduly large losses and lessen the likelihood of a larger financial
meltdown. But when the government implicitly insures debt holders by
bailing them out in bad times, the incentive to monitor borrowers is
reduced. The inevitable consequence will be much larger and more costly
crises in the future.

Government action might well be required to address this problem.
But it would be a big mistake for legislators to focus on regulating
leverage, the activity perceived to have caused the current crisis.
Instead they need to concentrate on undoing the perverse incentives to
take on risk that results from the perceived willingness of the
government to bail out large risk takers. As matters stand right now,
it is clear that once investment banks (or whatever these risk-taking
entities will call themselves in the future) reach a certain size, they
become too big to fail, and thus the entities that hold their
liabilities know they can implicitly count on a government guarantee.
Competitive debt markets will internalize the implications of this
guarantee, and the result is that large investment banks will find that
they can borrow at artificially low costs of capital, providing yet an
additional incentive to take on more risk. Because smaller banks will
not have this implicit guarantee, they will be at a competitive
disadvantage in this highly competitive environment. The likely result
is further consolidation of the industry and a compounding of the

To avoid the mistakes of the past, legislators should begin by
taking as given the incentives investment bankers and their lenders
face. It is naïve to believe that it is possible to control these
incentives by passing tough new laws regulating specific activity such
as the amount of leverage. Such regulation would soon become archaic as
investment bankers invent new financial products that could achieve the
same results without running afoul of the regulations. Instead
legislators should consider reorganizing the industry to better align
its incentives with the public interest.

Although a full analysis of how this can be achieved will require
time and data, there are two policies that I believe are worth
considering. The first, which I have alluded to already, is curbing the
size of investment banks. By keeping them small, failures can be
allowed in times of crisis without endangering the entire economy.
Consequently, government can credibly commit to not bail out these
institutions. Debt holders will then have incentive to aggressively
monitor these institutions, greatly reducing the likelihood of future
financial crises.

A second approach would be to align incentives by reconsidering the
corporate structure of investment banking. Less than 10 years ago
Goldman Sachs was a partnership. If Goldman was still a partnership
today, its partners would be personally liable for all of Goldman’s
losses. That is, it would not just be their current bonuses that would
be on the line, but their entire personal wealth. Faced with the
potential of personal financial devastation, it is extremely unlikely
that the partners would have allowed the firm to get into its current
financial straits. By reorganizing investment banks into partnerships,
the likelihood of another financial meltdown would be reduced far more
than, for example, through restrictive regulation on their borrowing
and lending activities.

One might argue that reorganizing investment banks as partnerships
would reduce their incentives to take on risk and thereby hobble their
ability to grease the wheels of capitalism. Such an argument might be
correct: The positive externalities investment banks provide by being
willing to take on risk might well outweigh the negative externality of
an occasional meltdown. But it is worth pointing out that for 130 years
Goldman Sachs operated as a highly successful and very profitable
partnership. If those enormous profits are indicative of the value
created in those years, one would be hard pressed to argue that the
partnership structure handicapped Goldman’s ability to take on risk or
otherwise serve as a valuable middleman.

I believe it is naïve to believe that we can protect ourselves from
future crises by simply passing tougher regulations. The political will
to make structural changes will likely evaporate once the crisis
passes. So although the window of opportunity to make structural
changes is short, it would be a mistake to rush to legislative action.
Congress should carefully consider how to align the incentives of risk
takers before taking legislative action.

Jonathan Berk is the A.P. Giannini Professor of Banking and Finance