George Packer writes,

The moral code of these Wall Street executives corresponds to stage one of Lawrence Kohlberg’s famous stages of morality: “The concern is with what authorities permit and punish.” Morally, they are very young children. The Swiss bankers are closer to stage four, most common among late teens, where a concern for maintaining the good functioning of society takes hold. Stage six, an elaboration of universal moral principles based on an idea of the good society, is a distant dream for the titans of global finance.

Thanks to Mark Thoma for the pointer.

I tend to agree with Tyler Cowen that individual moral propensities are less important than overall social context. To borrow from a different branch of social psychology, I would say that Packer is committing the Fundamental Attribution Error.

In my view, the problem comes from trying to use what I call letter-of-the-law regulation in finance. Call it L regulation. With L regulation, the regulator lays down specific, quantitative boundaries (think of risk-based capital requirements, with fixed numerical weights for various types of assets). The managers of financial institutions are told to stay within those boundaries.

In contrast, think of something I might call S regulation, for spirit of the law. With S regulation, the manager of a financial institution that enjoys some government protection would take an oath to maintain the safety and soundness of the institution. With S regulation, it is wrong to just tiptoe along the edge of the quantitative boundaries, without considering the potential risk to the firm.

Suppose we take it as given that government is going to protect some of the liabilities of some institutions, because of deposit insurance, implicit guarantees, “too big to fail,” or other reasons. I would like to see such institutions be covered by S regulation even more than by L regulation.

I would like to see managers of government-protected institutions take an oath to safeguard the soundness of their companies. I would like to see them subjected to prison terms for violating that oath. The oath is a general promise, not satisfied simply by staying within the boundaries of L regulation.

I believe that S regulation would change the motives of bank managers. They would be looking for ways to avoid failure, rather than for ways to stay within the letter of the law.

There can be plenty of risk-taking institutions in our society. But they should not at the same time be institutions that enjoy government protection when they fail.