Published in the Financial Times on April 15 2009

The supersonic Concorde aircraft was considered in the 20th century to be the most sophisticated airliner, flying at twice the speed of sound. Its crash in Paris on July 25 2000 destroyed this confidence. Some blamed the crash on metal fragments from another aircraft; others argued that Concorde was overweight and unbalanced. The accident led to some design modifications but in 2003 Concorde was in effect jettisoned in favour of subsonic aircraft, much slower but easier to maintain.

It is not too much of a stretch to compare the global financial system of the pre-subprime era to Concorde. It was fiercely innovative and grew at a record pace for close to two decades, only to suffer a new type of hard landing without clarity as to whether it was the fault of the system’s pilots or also of those regulating its maintenance.

While possible faults in piloting and maintenance of the financial system are many, the biggest contributor appears to be that capital allocation at large, complex financial institutions (universal banks, investment banks, insurance companies and, in some cases, even hedge funds) was broken, focusing myopically on circumventing capital requirements at the expense of long-term economic value creation.

For the current global market crisis, the primary fault lies with the pilots. These bankers and insurers paid themselves large cash bonuses by deceptively booking the income from triple A rated mortgage-backed securities as profits and ignoring their long-run risk/return trade-off.

But the regulatory maintenance cannot escape blame altogether. In fact, its cracks made the system vulnerable to pilot errors in the first place. In a world without regulation, creditors of financial institutions would curb risk and leverage by charging a higher cost of funding and designing tight contracts and covenants. But, in the world we have lived in, government guarantees (such as deposit insurance and “too-big-to-fail” policies) have been offered virtually for free and the financial risks have been socialised even as profits remain private.

For years regulation has targeted individual bank risk, when it should instead be managing systemic risk. Financial institutions will attempt to exploit government guarantees if that is in the interest of shareholders. That is what they are paid to do. So it is imperative to price the guarantees right.

Where should the regulators start to fix the system? Four changes seem paramount:

●  Change the compensation and incentive structure of traders and profit centres at large, complex financial institutions to provide reserve accounts that grow (“pay a bonus”) on good performance and shrink (a “malus”) on bad performance, essentially bringing clawbacks into compensation schemes.

● Prevent obvious regulatory arbitrage and charge for socialised risks – deposit insurance, too big to fail, temporary loan guarantees and the like – with pricing schemes that reflect ­balance-sheet leverage and risk in a continual manner. This will discourage size and risk distortions in a market-orientated way – rather than by fiat – and impose higher charges in good times if they lead to bigger banks and more leverage.

● Quantify the systemic risk of large, complex financial institutions and “tax” their contributions to systemic risk through capital requirements, or deposit insurance fees, or mandatory insurance purchases from private and public sectors. The need for a systemic risk regulator who performs this role and manages the failure of these institutions is only underscored by the growing size of the few remaining operators in the financial arena.

● Enforce greater transparency of over-the-counter derivatives and off-balance-sheet transactions, using centralised clearing for standardised products such as credit default swaps and indices and keeping central registries with trade transparency for all others.

The recent meeting of the Group of 20 went some way to set the system to rights. First, there seems to be general agreement that regulators should work together on a core set of principles. Without such an agreement financial institutions will be able to cherry-pick their jurisdictions. Second, at least from our point of view, the G20 has homed in on most of the important threshold issues, especially the focus on systemic risk, opacity and compensation within the financial system.

We think the issues of implicit and explicit government guarantees (the second point above) warrant far more air-time at future G20 meetings. A solution as simple as pricing these guarantees at the appropriate market rate will help solve the problem, as higher fees for higher systemic risk and leverage will organically lead these institutions to lower their risk profiles.

Some say that the reforms being proposed are against the spirit of capitalism. We think the presence of government guarantees for systemically important institutions is a given. So ignoring them is unlikely to lead to pure capitalistic outcomes. Others say the reforms will inhibit financial innovation. We think this view also gets the issue wrong. The goal is not to have the most advanced financial system, but one that is reasonably advanced and robust. That is also what we seek in other areas of human activity. We do not use the most advanced aircraft to move millions of people around the world. We use reasonably advanced aircraft whose designs have proved to be reliable.

The global financial system may never return to its golden age. Like Concorde, it will be replaced by a somewhat slower but more stable engine that is less prone to very costly hard landings.

The authors are professors who have contributed to the recently published "Restoring Financial Stability: How to Repair a Failed System".

Also, see "A Bird's-Eye View" from the same authors.