Beyond a bailout, Wall Street needs new rules

The financial calamity that has befallen the United States quite obviously reflects Wall Street failures in leadership and risk management. But we couldn't have arrived at this crisis point without a fundamental failure of government. That failure must be owned up to and rectified in the weeks ahead, or even the planned $700 billion bailout will end up being just a band-aid.

Capitalism relies on markets to make the world go round. But as Nobel Prize-winning economist Douglass North has articulated, it's the government's responsibility to ensure a legal and institutional context that is conducive to well-functioning markets. "Rules of the game" distinguish a healthy free market from a destructively chaotic one.

The inadequacy of Wall Street's rules has now been revealed beyond argument. The full magnitude of this calamity has yet to sink in. The financial services industry was supposed to be one of the remaining sectors of US competitive advantage in a globalized economy. Instead, its malfunctioning has further jeopardized the economic security of the American people.

So as Congress considers a massive bailout intended to relieve firms of the toxic securities on their balance sheet, it must also pledge to rewrite the rules of the game. It's unacceptable to put Wall Street's recklessness on the taxpayers' tab without an ironclad guarantee that business as usual is over. But what should the new rules look like? A comprehensive answer – including the contours of the new regulatory regime that's needed – is beyond the scope and deadline of the immediate bailout. Still, a few of its essential elements are clear.

Wall Street badly needs a culture change at the top. Its leaders must come to view themselves as stewards of institutions for the long term, not as temporary operators of vehicles proficient at finding new ways to throw off wealth, with everything else – including impact on the public interest – a mere detail. Institutional stewardship will mean, in practice, forgoing some opportunities for making a killing when the downside of a bet gone bad may be to jeopardize a franchise.

America must also come to terms with the infirmities of our system of corporate governance. This is especially true in the financial sector, which combines outsized rewards for apparent success. The emphasis is on "apparent," since byzantine balance sheets make it nearly impossible to know whether a CEO is really succeeding.

It's unlikely that most boards of directors of Wall Street firms – charged with oversight of management, with the interests of shareholders and of the institution uppermost in mind – understood the magnitude of the existential risks being undertaken by management in the pursuit of profit. But without industry-appropriate and company-specific understanding of risk, meaningful oversight is impossible.

The exorbitant CEO pay on Wall Street could only be justified on the premise that the firms they led were creating reasonably durable financial value while running only reasonable risk; and that the process of creating that financial value – though perhaps not the work of angels – was at the very least not destructive to the real economy. Its further premise was that the boards of directors hiring CEOs could distinguish the superior from the inferior talents, and that the better talents demanded to be paid extravagantly. These premises – except perhaps the last – have been undermined by this crisis.

The most objectionable aspect of CEO compensation isn't primarily the unfairness of the few at the top taking more than their appropriate share, nor that CEOs could cash in their personal gains based on ephemeral financial value, nor even the absurdity of massive "golden parachutes" paid out in cases of failure. The worst affront to the national interest is that these compensation arrangements created incentives for CEOs to "roll the dice" in search of the biggest possible scores for the company (and, not coincidentally, themselves), with too little regard for the downside risk if they bet wrong. And with no appreciation for the potentially dangerous consequences of such gambles, in the aggregate, for the economic security of the American people.

In now bailing out the financial sector, the government must do more than cut a deal on the toxic securities. The bargain must include a fundamental reform of the rules of the game on Wall Street to better align its activities with the public interest. Policymakers can't possibly work out the contours of these new rules in a few days. That's why this week's agreement must be understood to be merely Act 1, with much more to follow.

But Act 2 must be truly systemic. Having belatedly recognized that business as usual on Wall Street is capable of mortally wounding our economy, it would be the height of irresponsibility for Washington to simply restore the status quo ante – minus a player or two. The price for this bailout must include an explicit embrace by Wall Street of responsibilities to the public interest.

• Andy Zelleke is a lecturer in public policy at Harvard Kennedy School and codirector of its Center for Public Leadership.