01/15/2013 12:42 pm ET Updated Mar 17, 2013

Greed and Punishment: Criminalize Moral Hazard to Fix Wall Street

One thing that our biggest banks are great at is taking unconscionable risks with other people's money, also known as moral hazard. From the subprime mortgage fiasco that brought down Lehman Brothers and the catastrophic bets placed on derivatives by AIG to the London whale losses incurred by JPMorgan Chase, our financial institutions have demonstrated repeatedly that they cannot be trusted to manage money responsibly.

Some of this led to the controversial bailout of our financial system after 2008 and will probably lead to further bailouts in the future. Too big to fail is not a policy of the U.S. government, it is a reality of our financial system, and the reason for that is counter-party risk. Financial institutions do not function in a vacuum. They have clients whose money they have been entrusted with, investors and lenders whose principal they use to ply their trade, small businesses whose existence depends upon the availability of credit, companies and individuals who depend on insurance policies to manage their own risk, and trading partners who take the other side of transactions. As a result, when a bank or insurance company goes down, it has the potential to take thousands or even millions of other parties with it.

The easing of regulations during the Clinton and Bush eras, which permitted financial institutions like Citigroup, Bank of America, and AIG to become the behemoths they did, is partially responsible for this mess. But I say "partially" because that is only one part of the problem.

The other part is the lack of personal accountability on Wall Street.

Currently, the only real deterrents to excessive risk-taking are laughably small fines levied against financial institutions by the SEC and a smattering of other government bodies, and occasionally shareholder lawsuits, but this system is inadequate and, for the most part, misdirected. Punishing a financial institution for the choices and actions of its employees is like burning down an entire neighborhood because one of its residents committed murder. The problem lies with the individuals who set the standards for the institutions, not the institutions themselves.

By individuals, of course, I don't just mean those executives who place the bad bets but also those who abet those decisions, such as their colleagues, the board of directors, and sometimes even large investors who have their own agenda. These are the parties truly culpable and who should be punished to discourage reckless behavior. Going after the institutions themselves serves no purpose but to hurt rank and file employees, customers, and small shareholders since they are the ones who ultimately pay for those fines and lawsuits; while the people who actually put the organization in jeopardy have sailed off into the sunset with millions of dollars in inflated compensation and legal indemnity.

It's a farce that needs to end now. Breaking up big financial institutions so that our economy's fate is not tied to theirs will certainly help but it will not be enough, for the wizards of Wall Street will simply find other arenas in which to gamble. The casino mentality in our financial markets will not abate until the gamblers themselves are reined in, and that requires personal accountability and severe penalties. Nothing less will do -- not in an environment where executives can make astronomical amounts of money through high-stakes betting without having to risk their own capital, and with no incentive not to do so.

Criminalizing financial decisions may sound extreme but only because the practitioners of those crimes can afford an expensive PR machine to whitewash the consequences of their actions. A bad loan becomes a regrettable business decision, a bad trade becomes a miscalculation of market timing, and a bad insurance policy becomes an actuarial error. Yet what these innocuously worded "missteps" really are are mini economic bombs, and when enough of them pile up, the smallest spark can trigger a chain reaction of explosions resulting in a total collapse of our system. In that context, criminalizing such decisions should not be a stretch at all.

The other reason that criminalization is not only justifiable but the only way to address the problem of moral hazard is that jail time is pretty much the only thing that scares most white collar criminals. Financial penalties or public tongue-lashings by Congress are a joke for people who make several multiples of the GDP of small nations and have the wherewithal to retire to some remote paradise after screwing everyone. For such people, buying their way out of trouble is simply a cost of doing business.

Take someone like Raj Rajaratnam, for example, whose $157 million fine (including all penalties and forfeitures) for breaking the law on insider trading was only 10 percent of his vast fortune (at least at the time) and so the real punishment for him is not the money but the 11 years in prison he has to serve. Insider trading is also instructive because it is one of the few financial crimes that carries a meaningful penalty.

We need more of the same.

Opponents of criminalization argue that executives who make bad decisions pay for it through clawbacks in compensation and through the plummeting value of their own stock options. That may be true in theory, but in reality clawbacks are extremely rare and for every Dick Fuld or Jimmy Cayne who lost their personal fortune due to their mismanagement, a hundred other executives, including several directly responsible for the subprime mortgage disaster, are either still profitably employed or have gotten away with golden parachutes and a complete lack of regulatory scrutiny; and if that is not a miscarriage of justice, what is?

It also sends a very bad message to Wall Street, namely that their pivotal position in our economy makes them bulletproof.

If the president of the United States lies to the American public, he can be impeached, if a policeman falsifies evidence, he can be jailed, yet that is precisely what housing loan originators, investment banks who sold those loans as collateralized securities while secretly betting on the collapse of the housing market, and the rating agencies who put their AAA imprimatur on junk, all did during the financial crisis, and so far the reckoning has been non-existent. Sure, some banks have been slapped with fines and some civil suits have been settled, but that does not punish those who put the entire system in that position in the first place, and even those heads that rolled have magically sprung up elsewhere to lead new bodies and claim new victims in the future.

Are financial institutions too big to fail? Unfortunately, yes, and I highly doubt that breaking them up will mitigate all the risk. But are the stewards of these institutions too big to jail? Definitely not, and if we want to see real reform on Wall Street, that is absolutely necessary.

SANJAY SANGHOEE has worked at leading investment banks Lazard Freres and Dresdner Kleinwort Wasserstein as well as at a multi-billion dollar hedge fund. He has an MBA from Columbia Business School and is the author of two financial thrillers, including "Merger" which Chicago Tribune called "Timely, Gripping, and Original". Please visit his Facebook page for more information.