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How to Fix Banking

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By Greg McKenna, aka Deus Forex Machina. He is the CEO of Lighthouse Securities and has spent past two decades in financial markets in a number of senior roles including Head of Currency Strategy at the NAB and Westpac. Cross posted from MacroBusiness

Lambert here. This article skilfully integrates several recent threads related to JippyMo’s latest but surely not last debacle, and ties them to a 4-point proposal from one-time BoA President Sallie Krawcheck in HBR for addressing governance problems at big banks “to better align management’s incentives with those of the long term interests of the business.” I can’t help but feel that a fifth point should be added, viz: 5. Investigate big banks for accounting control fraud, and prosecute criminals where called for. A few C*Os in orange jump suits doing the perp walk on national television would do wonders pour encourager les autres, and would “reconstruct” banking’s “top echelons,” as well. And aren’t proposals that don’t restore the rule of law to our famously free markets just tinkering around the edges?

* * *

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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18 comments

  1. Jack M.Hoff

    Simply un-socialize losses. They should be every bit as private as profits are. If the banks go Boom, too fucking bad. bye bye. There’s always going to be others to take their places. Hopefully many others on a much smaller localized type scale. Bigness is not necessarily more efficient than smaller. Bigness in anything can only survive through subsidized insurance, or an ability to steal.

    1. Calgacus

      Right. The “Free Market” wanted to drastically downsize the financial sector by the GFC. Took a lot of government intervention to prevent this, to keep the parasites alive. The one good thing about the gold standard & Hoover is that this sort of BS was impossible or harder. You can’t instantly print gold to give to the crooks who’ve corrupted regulators & politicians. So the Hoover era weakened the parasites too, while now the parasites are restored to health, while their host is not.

      Bigness is not necessarily more efficient than smaller. In finance, with the exception of an intelligent, well-run, responsive democratic government running and participating in the show, bigness tends to be less efficient, and is always more dangerous.

    2. Up the Ante

      Exactly.

      And in keeping with the trend in my recent comments, a more fitting rebuttal of the banker/police conspiracy could not be found.

      De-unionize the cops, let them learn private privation as servants of the banksters, conspiracy ‘taken down’. End.

    3. bluntobj

      This.

      Removing supports and allowing crashes is really the one thing that will cause risk adverse behavior in BoD’s and CEOs.

      When you transfer or remove risk via gov’t intervention or regulation, you get bubbles and spectacular crashes.

      In regards to “bigness”, the solution is that there must be a “ceiling” on the idea of economies of scale. Most M&A activity is utlimately found to be unprofitable for the client companies, but very profitable for the investnment banker or venture fund.

      Ruthless application of anti-trust law on extremely large organizations will keep scale on a more local or regional level, more responsive to their shareholders, and less prone to abuse on the ludicrous scale we see now.

  2. TK421

    Those might be good ideas, but they’re a little nebulous. “Don’t judge Managers by earnings”? Who’s is doing the judging in this proposal, and what should be done about the judgment, and what other ways should they be judged? How do we put these ideas into action?

  3. BDog

    Sallie Krawcheck is terrible. A corporate ladder climbing nitwit that throws lame talking points that sound good to the mentally challenged. Bring back Glass Steagall so they can all fail like they should have already.

  4. Ralph Musgrave

    I am baffled by Lambert’s desire to “better align management’s incentives with those of the long term interests of the business…” (see his second last paragraph).

    Both are very nicely aligned at the moment in that both aim to rip the taxpayer off!!!!!

    The aim should be that “better align the activities of banks with the interests of society as a whole”.

  5. F. Beard

    One does not fix a counterfeiting cartel; one destroys it or at least removes EVERY government privilege for it such as deposit insurance, a lender of last resort, legal tender laws for private debts etc.

    Borrowing short to lend long is gambling. Why then is it subsidized by government?

  6. WarrenCelli

    Ho hum…

    Another Vanilla Greed for Profit lament that posits reformist solutions when there is no viable means of reform because the government and its institutions — including the great deception Hahvahd — have been hijacked by the Pernicious Greed for Control crowd.

    It is all soooooo sad. Poor old fashioned Vanilla Greed for Profit, like a drunk standing in line to buy another bottle of cheap wine and a lottery ticket with its last few dollars, it confabulates and fantasizes about how wonderful things will be when it finally gets the winning combination.

    Slaps self on forehead and says, “Gee, I could have organized election boycotts!”

    Deception is the strongest political force on the planet.

    1. skippy

      Are there enough Rape counselors on the planet?

      Skippy… oh never mind, must have done something to deserve it.

  7. Susan the other

    Finance has gotten so out of control that it destroyed the basis for capitalism. That would be capital itself. 700 Tr in “derivatives” floating in a big financial digital cloud and used to hedge a tiny amount of collateral which in turn is derived from an even more limited amount of natural resources? I keep thinking about the clear pessimism of Das and Bhide this last week. No amount of tweaking is going to fix this stupid system.

  8. Sid

    From 1983 to 2007 the percentages of net worth and financial wealth for the top 1% remained steady. But the percentages for the rest of the richest 5% increased by almost 20%, while the percentages for the lowest 80% of the population DECREASED by almost 20%. [This is called war], not “fixable” as much as well entrenched but reasonable “stooges” will write on behalf of the status quo’s illegitimacy. It’s over, give it up.

  9. craazyman

    this is like trying to tweak your diet so your turds don’t smell. I suppose it’s possible in the extreme, if you eat only lettuce, but these piggy bankster turds are so smelly I don’t think you can tweak their diet like this and think you can leave the ouput in the corner of your room. haha. No man, open the window, bring back the big Glass Stegal and let these suckers go down the toilet when they need to.

  10. J Shannon

    The most common thing about common sense is that it is in fact and reality very uncommon.
    When you give a bank your money there are only two possible outcomes – you get it back or they steal it!
    Banks use other people’s money to make money FOR THE BANK!
    If they loose your money they could care less!
    If they loose a lot DADDY Treasury comes to the rescue and uses OUR money to bail them out.
    Americans are too stupid to believe what is clearly going on.

  11. TheFreestMarket

    Lets keep things simple and fair.
    Give the banks 100% of what they want and what the rest of us want.
    Banks do what they want, without government.
    End deposit insurance. If a bank loses your money, we all sue and get it the old fashioned way, through lawsuits of the firm, management and individuals.
    End access to the fed window.
    End all differentiation in tax policy for banks and related entities.
    Let the banks walk their own way and exist in the “free”market they want.
    no bailouts, no help, no access to congress, white house, fed, treasury, comptroller of currency, nothing.
    Have fun boys and girls.

    1. F. Beard

      Not quite enough:

      1. End all US Government borrowing. This is a gift of a risk-free return to the banks. End it.

      2. Let the US Government establish a risk-free fiat storage and transaction service that makes no loans and pays no interest. The service would be free up to certain limits. This would deprive the banks of massive amounts of reserves. The Post Office could serve as branch locations.

      3. Abolish legal tender laws for private debts. Legalize private currencies for private debts.

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