How to fix banking

Over the weekend, there was a convergence of very good articles arising from JPMorgan’s illustration that not much has changed in banking. These articles showed that there are better ways to align management with outcomes that balance the needs of national and global economies beyond the current privitised gains and socialised losses approach.

The first of these articles was by Sell On News at MacroBusiness. Titled “Derivatives need a Priest” SoN posed the question about markets and what are they for:

…we can ask how it was that a system created for people ended being blind to people, especially weaker people in places like Greece? In this anthrosphere we have created, the one thing we seem most averse to is putting human beings at the centre. Much better to see it as a machine, and to spend our time poking it to see how it works.

Indeed. In abstracting people from the equation and viewing not only the system but the individual banks and finance institutions as machines we create a distance between ourselves and those machines in a manner that allows some to claim observer status not ownership. At the more complex financial institutions, this abstraction can separate individual departments and traders from their own organisations.

Which brings me to a piece by Barry Ritholtz published in the Washington Post on the weekend, about the similarities between AIG and the recent JP Morgan experience. The nub of what Ritholtz says is:

Finance has become a low-margin, high-leverage business. This is not surprising in an environment in which trading volumes are exceedingly low and interest rates even lower. In any other industry, a slowdown in economic activity sends management scurrying to cut costs, develop new products, become more productive. In short, to innovate. Companies can throw money at new products, marketing campaigns or discounted pricing, but a slowing economy brings down demand. What we have today is a deleveraging economy, and that is even more challenging — limiting the options that CEOs can take to increase their company revenue.

The world of finance refuses to accept that reality. Whenever Wall Street is confronted with a decrease in profits, we see the same response: Increase leverage. We usually don’t hear about it until some market wobble causes the excessive leverage to blow up in someone’s face. This time, the novelty cigar was smoked by Dimon, and the damage was inflicted on his reputation. The losses, we learned, were a “mere” $2 billion, described as manageable.

Consider any major finance disaster of the past 30 years, and what you will invariably see is the result of trying to spin dross into gold. The magic of finance is that this can work for a while. The reality of finance is simple mathematics. Eventually, the probabilities play themselves out and the dice come up snake eyes.

He is dead right – the world of finance does appear to be unable to accept reality – the bigger financial institutions, the SIFI’s, almost feel like they are trading to their heart’s content in the knowledge that they are simply too big to fail and someone else will pick up the tab if they get it wrong.

All of Ritholtz conclusions are on the money but here are a few that are pertinent for this discussion today:

Regardless, the error at JPMorgan unwittingly reveals much about the present state of finance:

● Bankers remain imperfect, overreaching and bonus-driven participants;

● When using other people’s money, the promise of enormous bonuses is still weighed heavily toward excess risk-taking;

●No major U.S. money center bank has demonstrated an ability to manage proprietary trading risks. None.

●If traders have forgotten the lessons of the financial crisis less than four years later, what sort of reckless speculative risks will mis-incentivized persons be doing after 10 years?

Which brings me to the article in the Harvard Business Review from the June Magazine, Sally Krawcheck’s  Four ways to fix the banksWhile it is based on the situation in the United States it has broad application for other markets. Echoing what Ritholtz has alluded to Krawcheck says:

It is tempting to view the financial downturn as a closed chapter whose primary causes have been resolved—perhaps not perfectly, but fairly comprehensively—by the Dodd-Frank Act’s reregulation of the financial services industry. But big banks continue to have a governance problem, which poses significant risks not just to them but potentially to the entire economy during the next downturn.

She concludes:

  1. Pay Executives with Bonds as well as stocks
  2. Pay Dividends as a percentage of earnings
  3. Don’t judge Managers (just) by earnings
  4. Give Board scrutiny to booming businesses too

I encourage you to read this article. Krawcheck is saying that there is a way to better align management’s incentives with those of the long term interests of the business. If the leverage ratio at a bank increases then so does the percentage in executive compensation that is paid in bonds, not cash or equities. This will increase the incentive to worry about the return of money as well as the return on the money. This should become a self-limiting constraint on overall financial leverage. I’d extend this idea down to the divisional head level so that there is an alignment of incentives vertically throughout the organisations.

Banking at the top echelon remains unreconstructed after almost 5 years of the GFC but there is no reason why policy makers should not push harder to incentivise the boards and management of SIFI’s to better serve the needs of the economy and to rebalance the asymmetry of benefits and costs away from privatised profits and socialised losses.

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  1. What is needed is an equal focus of bank CEOs on risk and reward, not just reward. As mentioned above, risk is nothing when the taxpayer picks up the bill.

    What about the bankers bonus gets paid into a pool which progressively gets released to the banker (whether they are still employed or not by the originating bank) once the investment in debt or other financial instrument proves itself to be successful. Eg for a home loan lend, the bonus pertaining to that lend would be release once the loan has been paid out or satisfied. Alternatively if there is a default, then the bonus is not paid to the banker but used to cover the loan losses. One measure to get them focused on risk and align the interests of the community, the bank and the bank CEO and hopefully reduce bubbles!

    • Mirage. I am a school teacher and the vast majority of my reward comes from the satasfaction of having done a worthwhile job as well as I could.

      Money rewards are secondary and this approach is fairly common in the sector.

      The culture of finance is such that there is a general myopia to measures of anything including success outside of ‘big bucks’.

      To ‘fix finance’ the foundation needs to be relaid using social / moral principles.

      For this to occur the existing ediface must be demolished. That is the process we are witnessing now.

  2. A government owned bank that provides finance to productive enterprises and provides competition via lower costs as well as restriction on the issue of high quality government debt.

    They will end up being nationalised in the longer run if they havent behaved themselves, better off having a CBA equivilant to keep em honest ( as much as that is possible)

  3. So how are any ‘reforms’ ever actually going to take place when money loops from public to private pockets back and forward between Wall Street and Washington?

    You’ve got to reform the political system first to eliminate legal bribes for as long as Wall Street continues to buy off Washington, as we have seen since the GFC, nothing will change.

    As the GFC clearly wasn’t a big enough shock to reform anything, we will inevitably have to see a much bigger systematic failure to bring it on.

    As ‘Too-Big’ firms like JP have an blank cheque to US government cash.. they will just keep betting until something blows up spectacularly, after-all, they are so juiced-in that no mater what happens, the perpetrators will walk away with their fortunes in tack and never face prosecution. There is no down side for Wall Street types.

    • It’s an extremely dangerous situation you describe, not unlike that described by Hannah Arendt in “The Origins of Totalitarianism” where in the late 19th and early 20th century there exists a moral cataclysm in the mainstream parties. They become so indifferent and unresponsive to the desires and necessities of the masses that they become, as far as the vast majority of the people are concerned, simply irrelevant. This enables the rise of mass movements, which under some circumstances (such as in the US and UK) are quite positive and other circumstances (such as Germany and Russia) quite negative.

  4. “Banking at the top echelon remains unreconstructed after almost 5 years of the GFC but there is no reason why policy makers should not push harder to incentivise the boards and management of SIFI’s to better serve the needs of the economy and to rebalance the asymmetry of benefits and costs away from privatised profits and socialised losses.”

    Desirable, but is it possible DFM when the bankers live in a world where they serve in a bank, go to being a regulator, and then back to academia? They might serve in Treasury as well, or a big corporation, but is there the incentive to change? Look at APRA for an example.

    In fact since the Great Recession/GFC I’d argue banking and the markets are a lot worse, and we see MF Global, JPM, GS, and who know who else is up to no good. Markets are more irrational, and with HFT (check out nanex)who is steering this ship?

    Their were a lot of good ideas at 2012 iNET, but like most of this hard to do stuff, it probably won’t see the light of day.

    I agree with the theme of your post however. Something should be done. We need to put the same scrutiny on politicians, and we’d see less rushed flawed policies IMO.

  5. “It is tempting to view the financial downturn as a closed chapter whose primary causes have been resolved—perhaps not perfectly, but fairly comprehensively—by the Dodd-Frank Act’s reregulation of the financial services industry.”


    Why don’t the banksters regale us with other fairytales?

  6. Nationalise them.

    Any idiot can lend money, but it takes someone with a sense of social conscience to lend for the benefit of everyone.

    They make $24 Billion profit to manage a big spreadsheet, which they fudge anyway….. We will probably end up having to do it anyway…..

    • In retrospect, the govt is just as worse. Someone create a social website that facilitates lending and borrowing……