Guidelines for Building a Better Financial System

There's been much talk about how deregulation was the cause of the financial crisis and we need better regulation to prevent a financial crisis. This is a bunch of nonsense. The problem in the way our financial system operates is actually a very old one: it's the agency problem. The people who make the decisions for all of these firms are heads of the large financial companies who understand the most about the risks they take. Not only do these people understand the risks the best, but they also have a very skewed incentive structure. The heads of these companies get bonuses from making the firms money, but when the firms go bust, the people that've made those decisions still end up with lots of wealth.

So now the problem becomes a little bit clearer. The people who make decisions about finance are the same ones who have no incentive from actually making good decisions. The tradeoff these people face is that they make a lot of money if the firm does poorly or okay while they make even more money if the firm does well. Now, the problem becomes even more clear: the people who make the most important decisions in our financial system not only have the most understanding about the risks involved, but they also have absolutely no skin in the game.

The solution that's currently taken place is that we've got a set of politicians whose largest donors are the country's largest financial institutions write "regulations" whereby the people who wrote the "regulations" do not suffer from the negative consequences if the "regulations" are bad. On top of this, the same people who wrote the regulations are being paid by the guys who the "regulations" are supposed to be written for. It doesn't take a rocket scientist to figure out something isn't right here.

In addition to having inverse skin in the game, the financial regulatory agencies (ex. SEC, FTC, etc.) are run by people who were formerly employed by the financial industry and people who will probably be employed by the financial industry if they were to leave to work for the private sector. In other words, we've got another inverse skin in the game problem coming from a revolving door. Yet we also expect these people to the "right thing" even when the "right thing" involves going against their own interests. Obviously, this doesn't make any sense and has zero chance of working.

It's clearly obvious that the problem here isn't a lack of "regulation" and that we don't need "more regulation". What we need are people making decisions who actually suffer the negative consequences if they make mistakes, especially considering that the people making decisions are also those who understand the most about the consequences of their actions. In other words, what most of these bureaucrats do is effectively useless. These "regulatory agencies" are effectively parasites.

What we don't need are more complicated rules and regulations, but simple and clear rules. We don't need more agencies; we need better compensation systems. So what're the solutions?

1. Eliminate almost all regulatory agencies. These agencies, not ironically, have an obvious agency problem that needs to be eliminated.
2. Change the incentives of corporate executives so that if the financial firm goes bust, every single person who was in the board of directors and all of the top corporate executives over the past 15 years will have all of their assets liquidated and be personally liable for the losses of the firm.
3. We also need transparency. This means that every single financial firm must publicly post all of its assets and liabilities on its website with absolutely no exceptions. If there is any sort of lying about the assets or liabilities of any financial firm, every single person in the board of directors and all of the top corporate executives should be tried for fraud with a minimum sentence of 7 years in prison.

Some might say that my rules are too harsh on the people who run these firms. If anything, my rules are not harsh enough. All I want is for those who make the most important decisions to be on the hook for the losses. The current problem with financial firms is that those who make the decisions do not suffer from the negative consequences of the decisions. Note that I do not care how much these people get paid. Choosing how much each person deserves to get paid or saying that one person "makes too much money" is stupid because there's no objective way to decide how much each person should be paid. If my rules lead to corporate executives being paid more money, I don't care because they will suffer the consequences of their actions.

Some might argue that these rules would cause many to not become corporate executives. To this I respond: if you can't handle the heat, then get the hell out of the kitchen. Right now, the guys who run these firms have no skin in the game. We need to have every single one of the corporate executives to make sure that they've got their necks on the line.

Note: These regulations would only apply to publicly traded financial firms, not firms like limited partnerships.

Note #2: There's a very good argument to say that these rules should be applied to the corporate executives for all of the publicly traded companies that currently exist. Personally, I think these rules should be applied to all publicly traded companies, but that's a different argument for a different day.