Why regulators should focus on bankers’ incentives
bankunderground.co.uk
bankunderground.co.uk
– Admiral Hyman G Rickover, United States Navy
I think the main problem is a classic principal/agent situation. The person who hires the bankers is often paying with someone else's money. This is really no different to other forms of enterprise sales.
I think both are massively corrupt, but there seems to be a disproportionate amount of breath wasted on bankers as compared to other salesmen.
Putting aside the question of how valid the analogy is, banking deserves the focus because of its importance to society, and the degree of harm it could cause.
Neither provides fundamental utility to other sections of the economy through lending activity, which can result in liquidity events at otherwise perfectly solvent firms.
Neither can drive prices in other sectors through speculation in financial instruments or through financial reporting and reporting downgrades.
Leverage is not the sole determinant of risk. Wildcatters are far riskier than someone who is 10x leveraged and holds 2 year notes.
> Neither provides fundamental utility to other sections of the economy through lending activity, which can result in liquidity events at otherwise perfectly solvent firms.
You picked the method of harm that is unique to finance. I could just easily claim that bankers will not build faulty levees or cause untold harm to the planet.
> Neither can drive prices in other sectors through speculation in financial instruments or through financial reporting and reporting downgrades.
It's not obvious to me that this is a method of harm. If oil is underpriced in the US and overpriced in Europe then buying one and selling the other will cause a shift in prices. Arguably this is a benefit because now everyone is paying/receiving fairer prices.
Regardless, bankers are neither traders nor research analysts so I'm not sure how relevant this is.
I seriously doubt that car salespersons' incentives are a noticeable factor in global warming.
It is not unreasonable for the category to be extended to include financial-industry incentive risk in general.
How about if you put up an argument for your position? Just one, to start with.
> I think both are massively corrupt, but there seems to be a disproportionate amount of breath wasted on bankers as compared to other salesmen.
I'm not sure what you want to see. Do you want me to link to articles about corruption outside of finance? I'm not sure that I'm aware of a study on the amount of corruption in banking as compared to database sales for example.
Maybe banking shouldn't be either?
"The right amount" then is when expected losses are less than expected profits; with some safety factor. This is complicated by allowance for both rare really bad sets of loss all at once and absorbing losses over a longer time. I think the solution for both is insurance. In fact, I really hope that the US FDIC (mandatory insurance for deposits, though it hasn't kept up with inflation) represents the basic insurance for the 10% figure you quote.
The recent housing debacle was fundamentally a banking issue: irresponsible real-estate dealing could not have happened, to any extent, without irresponsible banking.
Bank losses are socialized through deposit insurance. When a bank goes bankrupt, taxpayers make depositors whole.
Further, this article, and hence the whole thread, does not distinguish between banking and investments (like Glass Stegall did). Depositors are never affected by a bank going under (up to FDIC limits). Rather, securities holders are affected. Huge difference.
Even in 2008, banks did not get bailed out by taxpayers, they got bailed out by the Federal Reserve, which again, is not funded by taxpayers. [2]
[1] https://www.fdic.gov/about/learn/symbol/ [2] https://www.richmondfed.org/faqs/frs
- Steel Mills (in 1952)
- Railroads (most notably Penn Central in 1970)
- Car companies (all three in the last 40 years)
- Manufacturers (various)
- Utilities (mostly nuclear plants/companies)
- Airlines (post 9/11)
My impression is that most people believe the government will step in before any industry is ruined (assuming a quick decline, not necessarily a slow one over many years).
Criminal punishments (jail time) might work. I think that taxing transactions in financial products would help a lot more, making the finance industry smaller, which I think would be very beneficial to society.
This theory breaks down if you distinguish between banker and bank as per the article.
In the short term, the crooked banker with insurance can out-compete the honest uninsured banker by making high risk loans, not caring if the loans are paid back. In the short term the crooked banker can accumulate tens or hundreds of millions of dollars and happily retire when in the long term the loans fail and the bank goes bankrupt.
The honest banker has to explain to his share holders etc. why crooked banker's bank is growing so much faster than his bank. His borrowers have to compete for houses against borrowers from crooked bank who can borrow more and therefor pay more for houses. His "under-performing" bank may become an acquisition target of crooked bank.
The requisites for this dynamic are the absence of fear of criminal prosecution and perverse incentives via excessive CEO compensation.
Insurance isn't some magic thing that you just go get, it has a price set by well informed underwriters.
Making big banks smaller also will not help socially because banks have returns to scale in diversification. So bigger banks are less likely to fail by themselves, and can lend for lower rates, which is socially good (recent research [1] [2] indicates this might not be true for the biggest banks -- they exhausted benefits of scale).
Now one might ask if "too big to fail" effects might incentivize the bigger banks to act recklessly and counteract the above benefits? The answer is that there's the evidence does not back that up [3] at least for 2008 [4]. But that doesn't mean it is or is not the case going forward.
Why did banks act so recklessly if they were not acting on too big to fail incentives, then? The answer, like in the OP, is management incentives. The managers could not give less of a fuck if the bank failed, because they were incentivized by shareholders, in the form of bonuses, etc. to generate large year-over-year profits. And in any market close to efficient, the only way to do that is to take on large risks.
Not only did the managers not lose money if the bank failed, they didn't have any personal risk whatsoever. The lead up to 2008 was perfectly strategically rational coming from a bank manager's point of view.
As the poster above me says, one way to fix that is to impose penalty from the judicial system. There's only so much financial regulation can do. But DoJ has been awful at that, even clearly criminal acts (remember HSBC?) doesn't send management to jail.
[1] http://commons.colgate.edu/cgi/viewcontent.cgi?article=1053&...
[2] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2655448
[3] http://fic.wharton.upenn.edu/fic/papers/11/11-47.pdf
[4] Remember the official fed policy was not to bailout banks coming into the crisis. They let the first behemoth fail, but quickly realized the disaster that awaited the global economy if they let the next one fail.
Since recorded history, natural interest rates have hovered around 6%. We are at an unnaturally low period of history. With it has been the weakest recovery since WWII. That's a demand issue.
That's your interpretation. Mine is that Henry Paulson happened.
A smaller financial sector would stabilise the financial and economical system, albeit at a lower level of economic activity. The less rich and powerful suffer most from economic instability. They also stand to gain most from increased stability. Ask people from the Baltic states about what happened in 2008-2009...
Who is the biggest beneficiary of credit? Us, the rich and powerful!
Have a look at the most expensive thing most people ever buy in their lives: a house! Housing prices and interest rates are directly linked. More expensive lending would mean lower housing prices. To some extent, deflating that bubble is actually a good thing for the less rich and powerful!
That benefits people who can pay in cash. Otherwise, the difference in price goes to the bank as interest.
Especially those who are underwater on their home loan.
The industry shrunk in the great depression and also in 2008.
Do you really want to bring that on again?
Also, the rich get richer in recessions relative to poorer people.
I may be uninformed, but this does not seem logical to me.
I'd say that
1) a smaller finance industry has lower costs, which should more than offset other effects and
2) cheap lending is part of the problem itself, because this cheap money is used (by the finance industry itself and wealthy people) to buy things that are already there (such as real estate, or businesses), inflating its price, after which they will extract more rent from it, as it is now increased in value. This is much easier and less risky than investing money in new economic activities. I understand that only a small percentage of lending actually goes into new economic activities, the vast majority is used to transfer ownership of pre-existing things, increasing the costs for society.
First, what are you going to tax? Credit card use? Home loans? Business loans? Exchanging money? Debit card use? Deposits & withdrawals?
Secondly, making the financial industry smaller makes the economy smaller. There is a direct relationship. So if you want to shrink it, realize that your job, my job, and everyone here on HN will have their job at risk from a shrinking economy. The financial industry shrunk in 2008, and also in the great depression.
You might want to understand the cause and effect in the business before you make comments like your last sentence.
There are some simple solutions to the financial misbehavior, but politicians on both sides aren't interested in doing them. Shrinking the industry and taxing transactions aren't solutions.
People should be given a reason to do the right thing. Quite the contrary they are usually punished for doing the right thing. Whistle blowers have poor protection. Responsible employees get worse results than the reckless ones and thus get passed over on promotions or hounded by their managers.
It would be much more effective to simple get rid of all the incentives designed to only measure financial performance and nothing else. Pay people to do a good job, rather than according to a narrowly defined metric of performance.
The measurement based, new management style way of doing things has been poison everywhere in society not just banks. It causes police to arrest people just to fill their quota. Parking guards to write out tickets to meet target for number of tickets written by management. It makes hospitals push for unnecessary medical procedures.
It is time to stop treating people like greedy robots, and actually accept that people are blessed with compassion and the ability to make complex decision. They will do that if you let them, rather than rewarding them for being reckless idiots.
I think if you tried to refine these ideas into something more specific and concrete, that would apply on a daily or yearly basis with respect to employee performance and compensation, you'd see that this idea needs to be a lot more fleshed out. You haven't considered how incentives play out at multiple levels in an organization or how to construct the right ones.
There is no such thing as "just pay people for doing good work". The world doesn't have a ruler that can decree this and if it did there's still no way to enforce that it happens. You need to think about how to structure incentives for each person in the organization so that they shape behavior in the right direction. Personal liability is an incentive. "Pay people for doing good work" is not an incentive nor a policy that can be directly implemented. It is at best a goal that could be refined into policy and incentives after defining what exactly it really means. (What is "good work" and how do you know it when you see it?)
The author of the article is advocating for creating a much stronger incentive to do the right thing by making people who work at banks personally liable for the outcomes of their decisions. The author specifically makes the point that people outside the system don't how to recognize "good work", but people within it do, and by making them personally liable, they will think twice before doing bad work.
There has been very little action against banks despite continuous fraud in the UK. Yet we have dawn raids for bank employees who go "rogue".
The UK's only "industry" is banking. Their unique selling point is that you can come here and do whatever you like so long as you launder most of it through land to continue the UK fire sale to forestall total collapse.
"What if we build intelligent machines that execute their goals at the expense of humanity," we worry.