With his recent comments on the idea of breaking up the big bank stocks, Sanford Weill, former CEO of Citigroup, Inc. (NYSE/C), joins an increasingly large group of analysts, experts, and former employees within the sector who are raising concerns and voicing opinions that the current banking situation is in need of structural change. The comments from Weill and others who have worked in the financial sector are surprising in that their investment strategy for many years has been to increase the size and scope of the big bank stocks.
This is certainly a 180-degree shift in thinking regarding bank stocks and an investment strategy for them. With the financial crisis that ensued several years ago, it has become quite apparent that the complexity and incentive structure at bank stocks needs to change. The government coming in and supporting bank stocks when trouble arises has skewed the incentive structure and investment strategy of the people who work there.
I am all in favor of capitalism. One of the largest reasons that America has become the largest economic nation in the world in such a short time span is because of the incentive structure system built in a capitalist society. The problem is that in recent times, the incentive structure regarding the investment strategy of bank stocks has distorted the system. The hunger in a capitalist society is encouraged through the attainment of large rewards through risk-taking. Money is risked on new products and innovations, with successful investors benefiting. However, when a risky investment strategy has very little downside—for example, by having the government support losses—this changes the calculation for those making these wagers.
Bank stocks are integral parts of any economy; they are part of the engine that makes the economy function properly. This also means a proper allocation of capital. However, if the government is covering losses or preventing bank stocks from going under, this will lead to an incentive system where a high-risk investment strategy is taken on because the rewards are higher and the downside is limited. With no one fearing the threat of bankruptcy, bank stocks have misallocated capital.
Taxpayers should also not be on the hook for a bad investment strategy by the bank stocks. If an investor is willing to take the risk for an investment strategy, that is their decision. Taxpayers were never asked if they were willing to lend money in support of bank stocks that made poor gambles. This is not the capitalist way; this is more socialist in ideology.
We need to get back to a more capitalist economy in which risks and rewards are clearly defined. This means that the allocation of capital will be met with far more stringent requirements that are based on internal calculations by the bank stocks themselves. The market itself will regulate a proper investment strategy because the stocks will sell off if these investments turn sour. In the worst case, the punishment is that the bank stocks themselves will go under through their poor decision-making.
Because of the size of the big bank stocks, I do agree that having separation of business functions makes sense from a structural point of view. Having one of the pillars of the financial sector go under would be catastrophic. Having smaller, more nimble, and easier to understand bank stocks would give investors the ability to properly evaluate and analyze the firms. At that point, each section of the bank knows that their decisions regarding investment strategy policy will have consequences that won’t be supported by the government, which should result in better judgments being made.