There’s a clear problem with the banking system in a country where CEO’s can take huge risks, blow-up a company, adversely impact the economy and walk away with billions in compensation without having done anything illegal.  I am not generally a fan of strict regulation, but I make an exception for companies that rely on leveraging government money. Banks are unusual in that their ability to leverage government money makes them vital to a healthy functioning economy.  If the banks seize up as they did in 2008 then they can impact the entire system.  Remember, banks aren’t the engine of capitalism, but they are the oil that greases the engine.  If that oil runs out then the engine starts to run poorly or even break-down.

The problem with the current arrangement is multifaceted.  One of the issues is CEO compensation.  CEO’s are compensated in large part based on how well the stock performs.  So there is an incentive to maximize shareholder profits.  This often results in taking excessive risk because greater risk can lead to greater profits which leads to greater compensation.  So the reward for maximizing risk can be high.  Of course, if the firm blows up then the CEO gets to leave with their golden parachute and they go play golf somewhere for the rest of their life.  It’s almost a no-brainer.  Maximize risk and it’s a win win for the executive.  Of course, the problem is that a banking blow-up impacts everyone around the CEO and even the firms that do business with that bank.

The funny thing about the way our banking system works is that we allow banks this unique privilege of being able to leverage government money.  But then we decide not to regulate that money (at least not in a way that it stops them from blowing the whole system up).  From a functional perspective this makes absolutely zero sense.  The government has a monopoly on money and our government is strictly overseen by the populace, but for some reason the banks are allowed to leverage government money without strict oversight by either the populace or the government?   Where’s the logic in that?

One way of helping to resolve this issue is by requiring banks to be better risk managers.  Greater bank regulation and tighter capital controls would be nice, but executive pay is another way to align banks with the goals of the country.  The latest proposal, which is quite brilliant if you ask me, is to tie executive compensation at banks to credit default swaps.  A recent NY Fed article described how this would work and the logic behind it:

“Because stock- and options-based compensation is unlikely to curb the risk appetites of bank executives, Bolton, Mehran, and Shapiro in a 2010 New York Fed working paper proposed tying remuneration to a bank’s credit default swap spread. An institution’s CDS spread provides a market measure of the risk of a bank. Under our scheme, a high or increasing CDS spread would translate into a lower cash bonus, and vice versa. For banks that do not have a liquid CDS market, the bonus could be tied to the institution’s borrowing cost as proxied by the debt spread. However, the CDS spread has the benefit of being market based, and can be chosen optimally. It is the closest analogue a bank has to a stock price—it is the market price of credit risk. If CEO deferred compensation were tied directly to the bank’s own CDS spread, bank executives would have a direct financial exposure to the bank’s underlying risk and would have an incentive to reduce risk that does not enhance the value of the enterprise. Returning to our stylized example, we can see that moving from a flat salary to one where a portion of the compensation is contingent on a CDS spread adds a variable pay component that addresses shirking while explicitly making executives more risk averse.

How would this scheme look in practice? CEOs could be required to write a given amount of CDS (or to buy swaps written by other insurers) for the duration of their employment contract. However, a more efficient policy might use money set aside by the bank at the start of the period. Deferred bonuses would then be reduced or increased under a pre-specified formula as the bank’s CDS spread deviated from the average bank spread: bonuses would be increased if the spread was below average and decreased if it was above average. This approach has the added benefit of providing a built-in stabilizer. When banks are performing well and their credit quality is strong, bonuses will be paid out. However, when banks’ performance deteriorates and their credit quality weakens (leading to an increase in their CDS spread), they would be forced to conserve capital through the automatic reduction of bonuses. This approach is roughly analogous to automatically cutting dividends to protect the bank and its creditors. However, while cutting dividends imposes a cost on equity holders, this approach imposes a cost directly on risk takers.

Tying bonuses to a firm-level measurement such as a CDS spread (or a debt-like claim) motivates risk-taking employees to monitor each other to mitigate downside risk. CDS-based compensation may be particularly effective for risk avoidance because excessive risk taken by one employee can adversely affect all others, and thus linking compensation and risk is likely to shift the monitoring by outsiders to employees themselves.”

It’s a brilliant idea.  And it makes all too much sense.  If you want to help banks be better risk managers then make the compensation packages directly tied to how well they manage risk.  In doing so we’ll substantially increase the odds that the engine doesn’t run out of oil like it did in 2008.  Unfortunately, the idea will never fly because we still live in a world where irrational neoclassical economists rule the day and the oxymoron of a “free market” banking system (which relies on leveraging government money – ha!) dominates the debate in Congress.   This is only one piece of the regulatory puzzle and certainly wouldn’t fix all the problems, but like greater capital controls and tighter lending standards, this just makes sense….

This article originally appeared at Pragmatic Capitalism. Copyright 2014.