David Reilly: Tough love may save Wall St

Far from being a threat to Wall St, bonus-bashing French Finance Minister Christine Lagarde may end up being its saviour.

Sure, it might not seem that way at the moment: Lagarde has led the charge to curtail banker pay in the run-up to the meeting this month of leaders of the Group of 20 industrialised nations.

While calls for outright caps sought by the French were watered down last weekend in the face of Anglo-American opposition, Lagarde's push for global action on compensation won't die easily.

No worries. Wall St might come out ahead if the debate on pay spurred by Lagarde leads to a new embrace of the partnership model.

That structure served Wall St well for decades, and provided bankers with pretty lush compensation, before trading houses rushed to go public in a drive to become financial goliaths.

It would also blunt the need for more government meddling in markets. If bankers' own net worth is directly at stake, as it is in a partnership, there is a better chance they will more carefully weigh risks and be less willing to place big bets using huge amounts of borrowed money.

"By reorganising investment banks into partnerships, the likelihood of another financial meltdown would be reduced far more than, for example, through restrictive regulation on their borrowing and lending activities," Stanford University finance professor Jonathan Berk wrote this year.

How would a return to Wall St's partnership roots happen? Any push for pay curbs, as bankers will lament, may result in an exodus of talent from big banks like JPMorgan Chase or Citigroup and the remaining, big, publicly traded Wall St securities firm such as Goldman Sachs Group and Morgan Stanley.

That may occur even if, as now looks likely, the G20 only gives lip service to the French cry for bonus limits.

After US Treasury Secretary Timothy Geithner shifted the focus of the past weekend's meeting of G20 finance ministers from banker pay to capital requirements, the group issued a statement that only called for an exploration of "possible approaches for limiting total variable remuneration" at banks.

That was far short of some of the more stringent measures called for by France. Still, the threat is that the global, populist ire over banking pay will keep this debate alive.

So why would a banker want to stick around to see how it plays out? Better to get while the going is good.

If that were to happen, many fleeing bankers, traders and fund managers would set up their own boutique firms or investment funds. This would have a few benefits.

First, a talent drain would force too-big-to-fail firms to shrink. The people remaining would be those who want steady, boring banking jobs.

That's not a bad thing. Keep in mind that every time bankers try to make banking exciting, we all end up paying the price. And while this wouldn't solve the problem of too big to fail, it would help make such banks more manageable for regulators.

More importantly, fleeing bankers would know that if their new firms succeed and grow, they may run into the same sort of pay targeting that sent them out on their own in the first place.

The partnership model would act as a counter to any eventual compensation limits, since more bankers, traders and fund managers would derive their wealth from the holdings in the firms where they work.

That in and of itself wouldn't eliminate the chance that some financiers will make insane wagers, potentially prompting future crises. The danger will always be there. There's no assurance that Lehman Brothers Holdings would have survived even if it had never gone public.

Yet the partnership model would temper the animal spirits that usually fire Wall St without gutting risk-taking. Nor would it vaporise the profit motive, a vital ingredient for any market economy.

Plus, there would be a new appreciation of risk, on a firm-wide basis.

When much of an executive's net worth is on the line, he or she tends to act more responsibly.

Executives in this position also pay a lot more attention to the risks that may be building in the firm outside their own particular area or trading desk.

As Steven Davidoff, a University of Connecticut Law School associate professor, wrote on his Deal Professor blog at the New York Times last year: "The partnership structure made the owners the managers of the company. It created a socially cohesive group with both moral and fiscal responsibility for their bank. If the bank failed, it was the partners' net worth on the line, and if profits were not made, these partners were not paid."

Of course, it would be better for everyone else if Wall St would return to the more stable partnership structure without government meddling in private pay matters.

Until that happens, though, we have to hope that by pushing and prodding the Street, France's Lagarde inadvertently becomes a capitalist tool.

- BLOOMBERG