Fixing the Banks

November 6, 2012

Having devoted two posts to defending the personal integrity of most bankers, who have been excoriated not only by Joseph Stiglitz, but by America’s common man as well (with rhetoric from left wingers and anyone who can hope to gain from such blame assignment, and this is a rather all-inclusive group), we now turn to what’s wrong and what to do about it.

Stiglitz is right that the bonus and stock option system of bank management is wrong. It tends to reward for short periods of performance, like one year. What’s needed is a longer period of evaluation, minimum of 5 years, long enough to let the performance of their decisions play out.  And, any amounts paid out in the early years should be minimal percentages, with clawback provisions in case loans, derivatives, or other assets created or decisions taken, turn out to have negative consequences.

Now, let’s point out that the same is good across all of industry. It’s not only bankers who use the short term incentive plans and have no significant penalties for failure across a longer term. If we want this to be the model in our particular form of capitalism, we could actually require that by a simple set of laws.

Another benefit would be to take Dodd Frank to a stronger level and take out all trading in derivatives, except to the extent it is at customer request to hedge interest rate exposure. We got partially there with Dodd Frank, but not all the way. Such types of activities and investments which are not clearly for customer business transaction support should be put into a separate entity by those who want to engage in it, with separate shareholders and separate management–e.g., the Wells Fargo Bank for Derivatives and Other High Risk Activities. Such entities would instantly be held to a much higher standard by their clients, considering that they are no longer protected by the strength of the bank and it’s huge base of customers. Capital demands on these institutions would be much higher, and those who want to play in this casino can do so without affecting the public.

This would, of course, leave bankers who want to write mortgage loans to their personal clients, to have the right to sell those loans. So, they could structure packages of such loans, dividing them into segments for investors of varying risk/reward appetites, and sell those structured products. Products of that sort are sometimes called credit derivatives or mortgage derivatives.  They wouldn’t be allowed to trade in those loans for their own account, but they would be allowed to buy them for their wealth management clients.

We should have minimum net worth and risk acceptance policies for wealth management investors who  accept products such as derivatives and hedge funds in their portfolio’s.

Next would be a limit on size. There is simply no way around banks being too big to fail except that. We try and try to come up with regulations that will prevent excessive risk taking, but for institutions (of any kind) which are leveraged 10:1 or thereabouts, there simply will always be a risk of failure. More on regulation momentarily.  So, we should define what is the maximum size to allow a bank to grow to, best defined in share of market. 5% would be a decent limit for consideration. Right now, we’re around 50% of the market when combining the four largest banks in the US. That’s too large.

The problem with regulation: We need regulations, but if they are too complex and if they require too much transaction analysis, the regulation is not effective. The reasons are that banks pay a great deal more for their decision making employees, such as lenders, and if the Federal Reserve’s hires, who generally know far less about loan analysis, try to 2nd guess the bankers, it just doesn’t work. They are directed to find problems, so they find some–but what they find are usually not the pockets of greatest risk, and an enormous amount of time and money is wasted on the part of the Fed and also the bankers. Better would be simple rules which end up forcing the unconventional loans to a different group of uninsured institutions.  Of course, this means some market controlled inefficiency ala Adam Smith, but the tradeoff is worth it.  Here’s an example of a simple regulation: Minimum 15% down payment on any real estate loan, no matter the credit strength of the borrower–and the 15% cannot be borrowed from any other party–must come from liquid resources of the borrower. This is easy to monitor, and those who need to borrow (and can justify) with less down, can do so at non-bank, non-insured institutions. Of course loans with 15% down can still default, but at least there would be a lot less–and the regulators can’t figure out which of the below 15% loans are risky, anyway. Many of those borrowers pay on time, but the down payment minimum would eliminate a significant segment of risk.

Here is another sure fire way to reduce risk for loans made by banks: limited liability. Banks should be prohibited from making loans with the borrowers exculpated from liability. There should be a minimum of liability that is required when borrowing from a bank, whether the borrower is consumer or commercial. 10% would be a good start. Competitive pressures have pushed banks to yield this valuable provision, and if it were universally required, bankers would welcome it.

And when commercial banks syndicate (sell to others) portions of the loans they create, they should be required to hold until full repayment, a portion of the loans made–again, 10% would be a good start. That way, they can’t persuade themselves that it’s a good loan for others.

Political campaign limitations should be voted in by the America people, since the Supreme Court is unwilling to do see it this way. We should not have massive amounts of money funding millions of advertising campaigns to enable election of people friendly to the wealth of the nation. This includes friends of bankers, but by no means limited to that industry.

And, those who work in government should sign a pledge not to work in any industry with which they had any association while in government, and we should not permit those in private industry to take on government oversight jobs involving the industry from which they came. A waiting period of 5 years should be sufficient. Similarly for lobbyists–5 year waiting period going in either direction.

This is just a start–but it would get us off to a good beginning to lesser risk, fewer failures, and less downside to the American public.

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