President Obama plans to stiffen regulation of the US financial sector, and critics are calling the planned changes socialism. However, this is far from the truth. In fact, the abuses that went on before the financial collapse were undermining capitalism, and changes are needed to regain a healthy capitalist system.
To understand how the financial system was undermined, we need to understand the nature of the gambles taken by financial companies. What they did was to take risks that had a high chance of a modest payoff and a low chance of a huge loss.
Why did they do this? So that the individuals involved could make money. Consider the following simplified example. Imagine that an employee can take a gamble with his company’s assets that collects a $5000 premium, but has a one in a million chance of losing $10 billion.
From the company’s point of view, this is a bad gamble because if we do this a million times, we will collect $5 billion in premiums, but we expect to lose $10 billion once for a net loss of $5 billion. However, things look very different from the employee’s point of view.
Suppose that the employee takes this gamble 200 times per day for 250 days per year. As long as the bad outcome never happens, the company will make $250 million, and the employee can expect an 8-figure bonus at the end of the year.
The employee gets to continue with these gambles collecting huge bonus cheques each year until the bad outcome finally happens and sinks the company. This is a disaster for the company, but the employee gets to walk away with tens of millions of dollars in bonuses.
The best part of all this is that the employees look like they are doing a good job making all this money for the company. As long as shareholders don’t understand the risk being taken, they will be very happy with the results until the fateful day when the worst happens.
This little game is very profitable for the management of financial companies and is the reason why regulators are focusing on trying to assess and control the total risk being assumed by financial companies. Viewed in this light, it is easy to see why dishonest management is unhappy to see the party end and would call any new regulations “socialism” or “communism.”
Of course, it could very well be that the new regulations will go too far or will constrain the financial system too much, but this is a risk that we have to take.