I heard rumblings on twitter and elsewhere about the financial world view discussion in Las Vegas last week at the #SALT conference, at which, Nassim Taleb and Larry Summers spoke (debated?) about the challenges we face in the financial system.

The two world views seem to be that Larry Summers thinks as long as we have enough capital to support the liquidity of our banking system, the U.S. economy…and the world, in general, can keep on keeping on. i.e. once the capital problem is solved, then there is nothing holding us back to keep innovating, working, trading, etc.

Taleb is not as impressed. He thinks the capital injected into the system was immoral (theft, effectively) and that there has been no fundamental change in the system to prevent the transfer of capital from the Treasury (taxpayer funds) to the Banks (liquidity providers for the financial system) in the future. He made his point by saying that if the U.S. raised interest rates, we’d quickly see our ‘liquidity’ dissolve…and then the Treasury (U.S. citizens tax payments) would be forced to ‘bail out’ the banks once again.

So, the real question is: How do we solve this dilemma?

The answer Taleb proposes is to embed ‘punishment’ into the banking system itself. And by punishment, I interpret it as 2 things:
  1. Limiting the scope of what a bank can participate in. i.e. making banking super well defined to liquidity provision…debt provider…NOT…an investor or speculator in the equivalent of equity. 
  2. In addition to the limitations and practical regulations imposed on banks, there would be executive compensation limits. i.e. no executive would get a ‘performance’ bonus as there is currently no provision for the executive who took the risks that earned the performance to be negatively impacted if the risk resulted in a bust. 

Because banking inherently deals in risk, by limiting the scope of the risk the bank can participate in and by regulating the compensation of the banking operators, there would be less incentive for the bankers to take outlandish risks. And if banks did fail, it would be easier to contain.

There probably needs to be some more fleshing out of what this would look like in the real world, i.e. how can govt. effectively adjust the current system so that banking can do its job but also practically implement and enforce any regulations that would lead to a more stable banking system.

The concept is relatively simple, but because of the size of the current system, the execution of a solution would involve multiple levels of legislation, regulation and enforcement…in addition to being clearly defined.