Heads I win, tails you lose...

There is a lot of ongoing discussion in the world's media about the so-called "scandal" that is the investment banking bonus system. While there is plenty to be displeased about, much of the available commentary is mis-guided guff that misses the point. The real issue is this: If individual "rain-makers" make a lot of money for their respective banks, then they should get paid. If, however, in making that money those individuals take big risks that under certain stressed circumstances could threaten their bank and potentially the entire financial system then those returns need to be risk adjusted. Currently that doesn't happen and that is where the major issue lies.

At the moment there is a huge "externality" in the financial system. An externality is an impact or cost on a party that is not directly involved in a particular transaction. In the financial system the externality is that bankers own the upside of the risks they take, but in extreme circumstances (like the ones we have seen) the taxpayer bears the external costs of too much risk. One of the central goals of effective economic policy-making is to "internalize externalities", which basically means that the risks and rewards are borne solely by the participants in a transaction. The biggest current conundrum of this nature for global policy-makers is climate change, with the financial crisis not far behind. From the environmental point of view - a Chinese coal-fired power station benefits from the price it can sell its power at, but the negative "externality" of its contribution to global warming is borne disproportionately by all.

The real aggravation with the bonus "scandal" is that the externalities within the financial system remain unmitigated even after all that has happened. Policy-makers have yet to "internalize the externality". Traders can take huge risks, where if their bets pay off they benefit significantly, and if they don't then shareholders, creditors and in extreme cases taxpayers all suffer. We have been in a similar position before.

In 1933 after the Great Depression the US government established the Federal Deposit Insurance Corporation as part of the Glass-Steagall act. FDIC provides deposit insurance which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. Today FDIC insures deposits at over 8,000 institutions with $13.5 trillion in assets. Insured deposits are backed by the full faith and credit of the United States, and since the start of FDIC on January 1st 1934, no depositor has lost a cent. FDIC is not unique and has been replicated in various forms around the world.

At the time, FDIC was an excellent concept - the banking system was much more localised than it is now, and most of the financing that banks had came in the form of deposits from it's corporate and retail clients. Consequently, the insurance premium that banks paid to FDIC covered most of the risks that could lead to a proverbial run, in the event that the bank took the wrong risks.

Close to 75 years on, in 2009, in terms of market protections the banking systems of the world haven't moved on much from the basic deposit insurance concept, yet in the interim period the changes in global capital markets have made the deposit insurance concept woefully insufficient. When Lehman Brothers was declared bankrupt last September its demise heralded a sequence of events that almost broke the entire financial system. As an investment bank, Lehman did not finance itself through deposits, but through international bond and equity markets, so FDIC was irrelevant to Lehman.

What needs to happen is a proper acknowledgement by all parties that the banking system is implicitly underwritten by an insurance policy written by the taxpayer. Currently there is no premium paid by the banks for that insurance policy. The only direct benefit to the taxpayer of that insurance is in the event that the banking system fosters an economic environment that generates high tax revenues and lots of jobs. In the recent past that benefit has been significant - global GDP growth was stellar, and lots of jobs were created - but as has become clear that economic boom happened on the back of a serious increase in the amount of risk in the system.

In order to internalize the externality that exists in the financial system, there needs to be some form of premium paid to central banks by financial institutions based on the amount of risk that they are taking. If each individual bank choses to take on more risk, then that is their prerogative, if less then likewise - just like a car or house insurance policy. If a person chooses to drive a fast, expensive car then they should pay more insurance, and they should pay yet more if they have a history of driving recklessly. There are of course practical issues with the implementation - where are the premiums paid for a global bank, how to measure risk and how to minimize what I will call the "Goldman effect" (political interference in pricing the insurance policy) - but the principal of the insurance policy concept is the best way to approach the heads I win, tails you lose nature of the banking system. If policy-makers get that right then the bonus issue will correct itself.