Wow. Our experiment is off to a great start—let's see if we can finish it off sooner than expected.
The key to effective regulatory reform is to find a credible means of imposing some pain on creditors.
Here is one possibility. The government has restricted executive pay at A.I.G. and banks receiving government funds, but this move fails to recognize that the richest bailout benefits go to creditors. Restricting compensation at these creditor firms would have more force — if it is done transparently, in advance and in accordance with the rule of law. A simple rule would be that some percentage of bailout funds should be extracted from the bonuses of executives on the credit or counterparty side of transactions.
Such a rule would make lenders more conservative, which would generally be a good thing. To make sure that this measure doesn’t choke off economic recovery, a workable plan would impose compensation restrictions only after the economy improves and banks are recapitalized.
Here is another option: Even in good times, when there is no threat of insolvency on the horizon, credit agreements should provide for the possibility of a future, prepackaged bankruptcy. Those agreements should require that the creditors themselves would suffer some of the damage — even if the government stepped in to bail out the afflicted firm.
There is a risk that these sacrifices will not be extracted when the time comes, but the prospect might still check the worst excesses of leverage.
The central issue here appears to be credibility: these kinds of things only work if creditors believe the government will have the guts to follow through with them when the time comes. So that means we need something like the equivalent of the guy who tosses his steering wheel out the window in a game of chicken. But what would it be? What could we do today that would credibly persuade creditors we're going to hold their feet to the fire tomorrow when systemic risk rears its ugly head again? Suggestions?