Reckless (mis)behavior and the need for Wall Street reform

As we were reminded this week when world stock markets plummeted dramatically after China devalued its currency, a stable financial system is critical to our economy and Americans’ retirement savings.

Although we can’t control how some countries handle their currencies, we can — and should — control other factors that lead to market crashes. In fact, Congress already has taken steps to begin to do so. In 2010, it passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which became law.

But lawmakers and regulators haven’t finished the job. There is much more to do to curb out-of-control Wall Street practices. Two in particular to highlight are the inappropriate linkage of bonuses to risky behaviors and high-frequency trading.

{mosads}Before the 2008 financial crash, aggressive loan-makers at banks made riches based on the quantity of mortgages originated, not their quality. Those mortgages fed the fee-generating securitization assembly line. High-risk traders at banks and hedge funds took it a step further, speculating on the fate of those original loans, to generate even larger sums. All of this shady behavior was encouraged by pay structures at banks and financial institutions, which rewarded the risky activities with excessive bonuses.

Dodd-Frank, specifically Section 956, required financial agencies to sever the link between reckless trading and out-of-control compensation practices.

This pivotal set of provisions directs six separate bank regulators in Washington to work together to “prohibit any types of incentive-based payment arrangement, or any feature of any such arrangement, that the regulators determine encourages inappropriate risks by covered financial institutions.” The rule was mandated to come into effect in 2011.

However, rather than propose tough language, the regulators first proposed a rule with little teeth. Their first cut of the regulation required only that a sixth of an annual bonus be withheld for three years, in case the profits proved illusory. A better proposal would have withheld the entire bonus for a longer period of time.

Regulators invited public input about this proposal and received more than 10,000 responses — thousands from regular citizens upset by the role Wall Street pay played in crashing the economy. People demanded that the rule be made stronger and that it more clearly decouple the incentives to take risk from pay structures.

Since 2011, this re-proposal of this vital reform has languished, and many blame the Securities and Exchange Commission (SEC). The financial industry — which wants to protect its lavish pay — continues to lobby hard against it.

A risky behavior that Dodd-Frank didn’t address is high-frequency trading, in which high-speed traders use turbocharged technology to beat out their competitors at the expense of average investors. The need to address this has taken center stage over the past several years after the acknowledgment that high-frequency trading worsened the 2010 Flash Crash and helped cause the markets to spin out of control. High-frequency trading also has clearly exacerbated the turbulent markets we’ve seen over the past few days, with high-speed trading firms making a killing off of rocky markets.

The solution: a small tax on Wall Street transactions.

A Wall Street tax, or financial transactions tax, is not a new idea; a similar tax was implemented in the U.S. from 1914 to 1996. Going back to this policy would mean levying a small tax on trades like stocks, bonds and derivatives. Several proposals have been introduced in Congress that would tax financial transactions at rates from as low as three pennies to as high as 50 cents for every $100 in trades.

The impact of such taxes would be tiny for average investors but critical for reining-in out-of-control traders. Since speedy trading result in profits of less than a penny when computers detect miniscule shifts in prices, a small tax on these sorts of trades would greatly shift the way markets are used — turning them back toward the long-term investment strategies that work better for Main Street investors.

Whether reining in excessive compensation to make sure that executives prioritize stable behaviors that benefit Main Street or moving toward the sensible Wall Street tax, it’s time for Congress and regulators to act. We need to finish Dodd-Frank and implement further reforms like the Wall Street tax to increase investor confidence and Main Street growth.

Gilbert is director of Public Citizen’s Congress Watch division.