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Stepan Lavrouk
Stepan Lavrouk
Articles (626) 

Warren Buffett Explains How to Improve Financial Regulation

The Berkshire chief thinks that incentives should be properly aligned

October 30, 2020

Warren Buffett (Trades, Portfolio) is undoubtedly a capitalist to his core, but that doesn't mean he uncritically accepts the idea that markets should be completely unregulated. On the contrary, he has often advocated for better and more transparent regulation of financial markets, as well as broader government intervention like raising taxes on the super wealthy and increasing various redistributive policies. In his opinion, these interventions are necessary to maintain the proper functioning of a system that has broadly served the country well. In 2010, he explained how faulty regulation of the banking sector led to the near complete collapse of the financial system back in 2008.

Carrots as well as sticks

In an interview with Fox Business, Buffett said there will always be banks that are too big to fail, even though he "hates" that idea. Given that this system is an inevitability, how does Buffett propose to regulate these institutions? One idea is to financially punish the CEOs and other senior executives of big banks that go under and have to ask for bailouts:

"If I were running things, if a bank had to come to the government for help, the CEO would forfeit all of their net worth, and that would apply to any CEO who had been there for the previous two years. I think you have to change the incentives. The incentives a few years ago were to report higher earnings every quarter. That's what Wall Street applauded, that's what the world applauded. It's nice to have carrots, but you also need sticks. The idea that some guy who is worth $500 million will be left with $50 million is not much of a stick as far as I am concerned."

Of course, the notion of aligning the incentives of executives with those of their companies is not new - this is the general idea behind the granting of stock options. However, as Buffett himself has said many times, the practice of handing out stock options does not really represent a proper alignment of incentives. To use Buffett's metaphor, it is the grant of a free carrot without the corresponding threat of a stick.

Stock options became a popular way of compensating higher management when the Clinton administration capped the amount of tax-deductible dollars that a company could pay its executives. Although this was done to combat the growing inequality between CEO and worker pay, companies were able to use the loophole of stock options to get around this legislation. In fact, stock options were (and still sometimes are) considered to be "free," in the sense that a company doesn't lose any cash by granting an employee options. They are, however, not free - they dilute the stock held by other shareholders.

Buffett believes that a management's incentives will only truly be aligned with that of its company if executives actually use their salary to purchase stock. That way, they will actually have money on the line and will suffer the downside risk of failure.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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