A Better Way to Make Bankers Pay for Crises?

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McKinsey once got a study from a major shipping company whose bottom line was suffering because the managers in its ports were keeping too many containers on hand. No one wanted to be short of containers and delay a shipment, so they all made sure to have enough and then some. Containers are a big cost item and management was keen to figure out how to get by with fewer.

Now the team could easily have had great fun building a big model of shipping flows and likely variability and done lots of analysis to figure out what the minimum needed level of containers was and how to have the right decision rules. Instead, the team changed the pay for port managers, so that on the one hand, they’d still be penalized if shipments were delayed, but they would be rewarded for minimizing the number of containers they had. Almost immediately, port managers were sending containers away and complaining if an influx of shipments left them holding a lot. The shipper was quickly able to reduce its stock of containers.

Since the crisis, there has been lots of debate on what to do about incentives in the financial services industry with little in the way of action. That’s because we maintain the fiction that major capital markets firm are private sector companies. Despite the fact that they enjoy subsidies vastly in excess of other industries, we can’t possibly treat them like the welfare queens they are and ride herd on their compensation levels.

But it’s still worth pondering the issue of what ought to be done, since pretty much every investor I know expects another big crisis in two to five years. We had better get it right next time.

The germ of a very interesting idea came in a VoxEU paper last March which I had wanted to highlight and somehow let slip. One of the problems with the big end of financial services industry is that it is highly interconnected, so if one firm gets in serious trouble, it is likely to bring the whole network down. Yet because bankers have perverse incentives (annual pay cycles and business unit level pay for most producers, both of which encourage narrow views of risks), banks routinely try to shift risk onto their counterparites, which is fine in normal times, but a destructive posture when markets become risky (the blow up of AIG and the monolines is a classic example).

Here is Hans Gersbach’s solution:
When banks failed, the government paid up. But the bankers responsible kept their bonuses from the years of excess. This column argues for “crisis contracts”….

Crisis contracts are designed specifically for members of the bank’s management. The nature of a crisis contract is as follows:

Definition of a crisis: A crisis occurs when the average equity capital in the banking system (relative to the assets) falls below a critical predefined threshold.
When a crisis occurs, the top managers of major or highly interconnected banks contribute a portion of their earnings from the previous years to a rescue fund for the recapitalisation of the banking system.

I think this idea is promising but would tweak it: a much longer lookback period (at least three years, with fund set aside rather than having to be clawed back) and including a broader base of managers (you’d want to include all profit centers running meaningful balance sheet risks).

This would also have the significant advantage of increasing incentives throughout the industry to monitor risks of counterparties, which also might even lead them to inform regulators if they thought a firm was engaging in risky practices.

Reader suggestions as to how to refine this idea very much appreciated.

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    1. Jack E. Lope

      The formula for that would be:

      (Salaries of AIG Execs)+(Salaries of GS Execs)/13 Billions

      Or would you posit that GS were the victims here?

    2. Karen

      As your example highlights, if this idea works at all it would do so by preventing executives from engaging in irresponsible behavior in the first place, not by making good on the losses after the fact!

      I think the old-fashioned approach of brute-force prevention (strict, restrictive regulation intrusively enforced) is the best. That way of thinking seems to be unfashionable for some odd reason – I think the free marketeers still have an amazingly strong hold on people’s thinking, considering how miserably their ideology has actually performed in real life, and how naive it seems even on its face. Would these same people propose abolishing the police and criminal courts so we can all be free to maximize our happiness???

    3. Cathryn Mataga

      There’s a point here. Thefts at this level are so damaging to the economy that current levels of punishment just don’t make sense. Maybe extra sentencing for the size of the crime would seem fair to normal people. For example…

      10M+ theft — Life in prison.
      100M+ theft — Life in prison — no possibility for parole.
      1B+ theft — death penalty.

      Hmm, would this seem fair to most people? We pass out long sentences passed out for small crimes, why not amp up the punishment for big ones?

      1. Jojo

        Reasonable to me. Under out current criminal system for corporate crime, there isn’t any deterrent for fraud, theft, malfeasance…

  1. RebelEconomist

    I am afraid I don’t think any of these cunning incentive schemes are going to prove to be satisfactory. If you believe that the price of a banker is set by supply and demand, such schemes will largely just timeshift when that price is paid. At the moment, while crisis is fresh in the mind, people tend to think about how much such schemes will punish the bankers for failure, while forgetting about the reward for avoiding failure. My guess is that, because we are now wary, there will not be a crisis for a while, meaning that in the near future under such a scheme, bankers’ compensation will be even more obscene, which won’t do down well either.

    My solution is to make top bankers’ jobs more contestible by empowering shareholders to get rid of them, while giving the shareholders the incentive to do so by increasing bank capital and ensuring that shareholders are written down to zero if the bank fails. As it has been, apart from a few cathartic exceptions like Fred Goodwin, the cast of senior bankers seems to be much the same as before, and shareholders in some of the biggest losing banks – eg RBS – were not wiped out.

    1. DownSouth

      Ah yes, the “let-the-stockholders-take-care-of-it” shibboleth.

      I think everyone by now knows that RebelEconomist doesn’t do reality.

      1. DownSouth

        For an excellent paper that takes a chain saw to the minimalistic assumptions upon which RebelEconomist’s Utopian ideology rests, there’s the paper by David Sloan Wilson, THE NEW FABLE OF THE BEES: MULTILEVEL SELECTION, ADAPTIVE SOCIETIES, AND THE CONCEPT OF SELF INTEREST:

        Mandeville’s fable of the bees, along with Adam Smith’s metaphor of the invisible hand, has long been used to convey the idea that a well-functioning society can be forged out of individual self-interest. This idea has become such a tenet of modern thought that for many it is an unquestioned axiom and for decades it has served as the foundation of formal economic theory.


        …I think the concept of self-interest in both evolution and economics owes its popularity to at least two factors. First, natural selection and rational choice can both often be represented as an optimization process in which a single variable is maximized, even when it is a very complex function of other variables. Second, self-interest is a highly simplified and intuitive case of optimization, in which an individual juggles costs and benefits to maximize a single utility. Thus, any optimization argument can be made intuitive by employing the metaphor of self-interest. Unfortunately, the intuitive appeal of self-interest is obtained at a cost. The details of what constitutes self-interest must change with the particular optimization model, which means that there can be no single concept of self-interest. In addition, optimization in general is poorly suited for addressing the specific question of when groups evolve into adaptive units. Among-group selection by itself maximizes the relative fitness of groups and within-group selection by itself maximizes the relative fitness of individuals within groups, but the entire process of evolution in multi-group populations is a messy combination of these opposing forces, along with other forces that prevent adaptations from evolving in any sense. Showing how groups evolve into adaptive units requires a consideration of opposing forces, not a process in which a single quantity is being maximized.

        1. Sauron

          DownSouth, you should read “The Ideal Society” by Joseph Heath (a Canadian philosopher). He takes on that assumption frontally.

          Unfortunately, I can’t remember much of the particulars of his argument (my copy has been on “loan” to some friend, somewhere for a looong time). But the “fire drill” and “no speeding” examples always stuck with me. People (at least in schools) line up when the fire alarm sounds because more will escape then if everyone pursues their own interest and rushes for the exit. The Netherlands? instituted a no passing rule on certain highways…it was found to lower average travel times.

          The problem is that there is a deep-seated Calvinistic belief in America. To paraphrase Gore Vidal, it is not enough that one succeeds, others must fail. This vitiates the entire assumption of the common good. It is proper that those near the exits escape, while those at the back burn. Those near the exits are there because they are deserving in some fashion, and it would be immoral to hold them back for the undeserving. What is important is not that we maximize the common good, but that we maximize it for the deserving.

          1. DownSouth

            In Darwin’s Cathedral David Sloan Wilson has an entire chapter on Calvinism. He observes that:

            The question is whether Calvinism is designed to benefit some individuals (presumably the leaders) at the expense of others within the church, or whether Calvinism is designed to benefit everyone within the church as a collective unit. Exploitation is sometimes naked, but more often it requires deception. Thus, we might expect Calvinism to appear good for the group at first sight but to emerge as a tool of exploitation upon closer examination. Some features of some religions undoubtedly can be explained in this way, such as many practices of the Catholic Church that led to the Reformation. Religious scholars have already reached this conclusion on the basis of qualitative information, and there is little reason to challenge it. I am not trying to explain every feature of every religion as good for the group, nor could I succeed if I tried. It is multilevel selection theory that explains the nature of religion, not group selection alone. Churches are subverted from within, which in part accounts for the formation of new churches, as I will describe in more detail in chapter 5. However, the details of Calvinism point strongly to genuine group-level benefits rather than an elaborate sting operation.

            According to the theologian Reinhold Niebuhr, the “subversion from within” of Calvinism into an “elaborate sting operation” was fairly rapid once it made the trip across the Atlantic:

            At any rate, the descent from Puritanism to Yankeeism in America was a fairly rapid one. Prosperity which had been sought in the service of God was now sought for its own sake. The Yankees were very appreciative of the promise in Deuteronomy: “And thou shalt do that which is right and good in the sight of the Lord: that it may be well with thee, and that thou mayest go in and possess the good land which the Lord sware unto thy fathers” (Deuteronomy 6, 18). A significant religious reservation about the relation of achievement to prosperity, which the Book of Deuteronomy also contains, was not heeded: “For the Lord thy God bringeth thee into a good land, a land of brooks of water, of fountains and depths…. When thou hast eaten and art full,…Beware that thou forget not the Lord thy God…Lest when thou…hast built goodly houses, and dwelt therein; and when thy herds and thy flocks multiply, and thy silver and thy gold is multiplied…then thine heart be lifted up…and thou say in thine heart, My power and the might of mine hand hath gotten me this wealth” (Deuteronomy 8, 17-17).

            Such religious awe before and gratitude for “unmerited” mercies was dissipated fairly early in American life. It remains the frame of our annual presidential thanksgiving proclamations, which have however contained for many years a contradictory substance within the frame. They have congratulated God on the virtues and ideals of the American people, which have so well merited the blessings of prosperity we enjoy.


            Any grateful acceptance of God’s uncovenanted mercies is [thus] corrupted from gratitude to self-congratulation [since] it is believed that providence represents not the grace of a divine power, working without immediate regard for the virtues or defects of its recipients (as illustrated by the sun shining “upon the evil and the good and the rain descending upon the just and the unjust”); but rather that it represents particular divine acts directly correlated to particular human and historical situations. Inevitably this means that providence intervenes to punish vice and to reward virtue.


            The Christian idea of the significance of each individual in God’s sight becomes, in bourgeois civilization, the concept of a discrete individual who makes himself the final end of his own existence. The Christian idea of providence is rejected for the heady notion that man is the master of his fate and the captain of his soul.

          2. DanJS

            Good idea… quoting scripture — but you omitted the “good part” following verse 17.

            18 But thou shalt remember the LORD thy God: for it is he that giveth thee power to get wealth, that he may establish his covenant which he sware unto thy fathers, as it is this day.

            19 And it shall be, if thou do at all forget the LORD thy God, and walk after other gods, and serve them, and worship them, I testify against you this day that ye shall surely perish.

            20 As the nations which the LORD destroyeth before your face, so shall ye perish; because ye would not be obedient unto the voice of the LORD your God.

        2. Sauron

          Just get rid of the entire private, for profit, banking system altogether.

          There is a public bank. You need 100 000 for a house. They look at your ability to pay, set a schedule for repayment, and loan you the money, and charge you a small paper-shuffling fee. No interest is charged because the object isn’t to make a profit, it’s just to provide credit.(Although payments will need adjusting for inflation.)


      2. Jack E. Lope

        The one thing I’d take from Reb is this call for a strong regulation:

        “…ensuring that shareholders are written down to zero if the bank fails”

        I’d go a little further, and turn any government bailout of any company that had not paid up front (such as FDIC insurance) into ownership-by-the-taxpayers (a.k.a. “Nationalization”).

        1. RebelEconomist

          Yes, especially capital adequacy and rigorous accounting. And whatever is done, it has to be sufficiently robust to survive calls to water it down when it becomes inconvenient. I am sceptical of bankers’ complaints about the pro-cyclicality of some regulations: http://reservedplace.blogspot.com/2008/08/its-wind-up.html

          By the way, I am confused by your remark about FDIC insurance. Do you know that this is not insurance for the bank itself; only the retail depositors?

          1. Jack E. Lope

            Yes, but no better example came to mind. (There may be no mandatory-coverage-from-a-government-entity left in the US….) Even if we institute a financial transaction tax (“Tobin Tax”), the rate is not likely to cover more than the ongoing cost of regulatory agencies – so I would not want to assume it carries any “bailout value”.

            In the case of FDIC, the method of restoring deposit balances includes FDIC taking control of the remaining assets (and, normally, putting those assets and the depositors’ accounts in the hands of a more-solvent deposit institution). Some might call that a form of [temporary] “nationalization”.

      3. RebelEconomist

        And your solution is? You keep ranting about criminals, but the fact is that incompetence and greed is not a crime, so you are barking up the wrong tree. Either that, or you are just barking mad.

        Has it ever occurred to you that, by making noise that distracts attention from more insightful contributions and is easily dismissed by the very people to whom you are so hostile, you are letting them off the hook. But perhaps it has, and you are a troll paid by the bankers to disrupt serious discussion.

        Readers of this post might be interested in this article: http://www.independent.co.uk/news/business/news/hsbc-directors-attacked-in-shareholder-rebellion-2290185.html

        1. Yves Smith Post author

          Sorry, fraud is. Doing something with the knowledge it was wrong is fraud. Banks routinely would cook their books at the end of the quarter, traders putting on bogus trades is the norm to boost reported profits and their P&L Is the norm, not the exception. Risk management at most firms is institutionalized blame avoidance, and not a serious exercise. That’s not my view, that’s per the report of Morgan Stanley’s former chief risk officer Roger Ehrenberg.

          This “people were just greedy and therefore not culpable” is tripe. They entered into contracts and broke them on a ROUTINE, INSTITUTIONALIZED basis. Just look at RMBS origination (failure to convey notes to the trust as stipulated in the PSA), failure to live up to the reps and warrantied re the credit standards of the notes conveyed to the RMBS. You have ongoing fraud in that the trustees and servicers provide annual certifications that they hold the assets as stipulated in the PSA (impossible given the failure to convey). You also have deliberate mismarks of CDOs, CLOs and other illiquid paper prior to the crisis (this was so well known I wrote about it here, which meant it was reported in the media). Dealers would enter into teeny trades with friendly counterparties on a mutual back-scratching basis to justify phony (exaggerated) marks. That’s clearly fraud. It was done with intent to generate phony public accounting.

          Your argument is sheer bunk and shows your refusal to look at the conduct of major firms in the runup to the crisis.

          1. RebelEconomist

            So, if fraud is illegal, have it prosecuted, and let that serve as a disincentive to future crisis-generating behaviour. I’m all for that. The trouble is, I doubt whether proven fraud will account for much of the losses sustained, eg at AIG FP, RBS or Northern Rock. Something more is needed.

          2. carping demon

            You know, Yves, you’re the only blogger I know of who can stay unerringly on task. It’s reassuring.

          3. ajax

            I suppose you have heard of the case against two
            former NYC Credit Suisse brokers, Tzolov and Butler, who
            were found guilty of criminal fraud (Tzolov may have
            plead guilty and become a prosecution witness in the
            Butler case). They were accused of knowingly
            misrepresenting the collateral for exotic bonds.
            The figure quoted for this fraud was $1 billion.
            They were convicted in a US district court trial, and
            at least one of the two ex-brokers is appealing to
            a higher court.

            They represented to investors that the exotic
            bonds were backed-up by student loans, as I recall.
            In fact, the exotic bonds were not backed
            (collateralized) by student loans.

            Butler is appealing in a US appeals court.
            I’m not sure about Tzolov.

          4. DownSouth

            RebelEconomit said: “So, if fraud is illegal, have it prosecuted…”

            Well what a bullyboy we have here.

            But when toughs taunt those they assume to be helpless, it doesn’t always turn out the way they predict. Here’s an excellent example:

            Old Man Knocks out Bully

        2. Ming

          People should be punished based on their actions and/ or the outcome of their actions; their motives are difficult to discern and internal to themselves and do not affect another person. Hence it is irrelevant whether somone was greedy or incompetent; if it was their actions that directly harmed another, or if it was their actions that that set conditions that made another person more vulnerable to harm, then they should be punished appropriately.

          If a person drives a car an kills someone in an accident, do we care if they had earned their driver’s license?

        3. DownSouth

          RebelEconomist said: “Has it ever occurred to you that, by making noise that…is easily dismissed by the very people to whom you are so hostile, you are letting them off the hook.”

          So let me get this straight. My calling attention to the criminal activities of these crooks is “letting them off the hook”? Well all I can say to that is: Who can argue with “logic” like that? What stunning cognition!

          Now I know that for someone like you who has their lips so firmly attached to Lloyd Blankfein’s ass that they can’t be pried loose with a crowbar it’s hard to believe, but the criminals are not really my target audience. I don’t really care whether the criminals can “easily dismiss” what I say or not. And even though you obviously believe the sun rises and sets based on these criminals’ every word, I could care less what these bastards think.

          1. Dan Duncan

            DownSouth, it’s in the “…” that you miss the point.

            Specifically, the part of RebelEconomist’s comment that you conveniently replaced with “…” was this statement from RebelEcon: “by making noise that distracts attention from more insightful contributions and is easily dismissed”

            The point, DownSouth, is that there may very well be more insightful contributions being made by other readers, but they are drowned out by your monopolization of the discussion.

            I’m not saying that you shouldn’t make comments. Come strong with them! Take your time…make your argument. Fine.

            But F*cking A, man—how many comments have you made today? 30? 40? It’d be nice to read what others have to say and to let them engage in some discussion without having to read your irrelevant block quotes at every freaking turn.

            Come strong. Make your statement. STFU and Move on.

            [Now, I know you’ll respond to this…[[And if you don’t, the only reason for your forbearance is because I said “I know you’ll respond to this”]]…but please learn from the example I’m about to set for you:

            I said what I have to say. You won’t like it. Others–if they suffered through this comment–won’t like it. And a few others, still…may actually agree.

            No matter. It is over. Let others have their say. Nothing else needs to be said.]

          2. DownSouth

            Gosh Dan,

            What would life be like without your frequent outpourings of joy and sunshine?

            Given your upbeat and positive outlook, your unparalleled command of factual knowledge, your kind words of encouragement for the down and out, and your judicious and considerate assessment of the issues, how could we ever get by without you?

            I know it must be a great loss for REDSTATE.com when you take time out from your regular routine to honor us with your presence.

          3. Brionie Pritchard

            @Dan Duncan

            But we all love DownSouth!

            Bog off, thou bawdy, beslubbering, beef-witted lewdster!

          4. Name (withheld)

            @Dan Duncan

            Why don’t you just ignore his comments the way most readers of this blog normally ignore yours?

        4. JTFaraday

          “The near-19 per cent vote against the pay report followed some similar revolts at Barclays and Lloyds Banking Group.

          Almost 14 per cent of the votes that were cast at a three-hour meeting went against HSBC’s new share plan for its top 50 people.”

          14 to 19 percent? *That’s* your shareholder rebellion? Did you *read* that article you linked to?

          1. JTFaraday

            “Mr Flint told a shareholder: “There is nobody sitting here or standing here that would disagree with the proposition that total shareholder return over the last five years has been not only disappointing but inadequate.””

            Not to mention that maximizing shareholder value will just drive them to be even more reckless, dumping the bill on the public for failure, lest next year’s shareholder vote eek past their current 19% disapproval rating.

            I especially like this line:

            “Mr Flint said he accepted shareholders’ points about the level of boardroom pay and condemned “egregious” and “horrendous” examples in the US. But he added: “It would be irresponsible to allow our comparative advantages to wither by ignoring the market forces that exist around compensation, even though we understand how sensitive the subject is.””

            Everything in that article is wrong to the point of insanity.

          2. RebelEconomist

            I thought it was an interesting article in the context of the present discussion, that’s all. Clearly, shareholders, especially institutions like pension funds, are not yet exerting much control over the firms they own. I suspect that the reason for that comes down to accounting and regulation. If the hole in the pension fund arising from bank losses showed up immediately, and the plan sponsor had to shell out real money to close the gap quickly, I dare say the pension funds would pay closer attention. Of course, governments are reluctant to enforce such regulations, because the loss in a corporate pension fund would depress earnings and therefore depress stock prices, and that would be unpopular. In my opinion, such simple changes could make a massive contribution towards stabilising the financial system and are hard to argue against, but are politically costly to introduce, so the politicians are happy to let the discussion focus on banker-hatred. My guess is that they love ranting fools like DownSouth.

  2. SH

    I think this is an oversimplification. You say that instead of analyzing costs and modeling shipments, not that hard to model, a container is either there or it is not, “… the team changed the pay for port managers, so that on the one hand, they’d still be penalized if shipments were delayed, but they would be rewarded for minimizing the number of containers they had.” Since when are less delays and less stock on hand bad business decisions? Pay structure payments had nothing to do with that or the fact that models were not used. Get me a good port manager, and I bet he minimizes the number of delays and containers sitting on site.

    Get me a good bank manager and I bet he maximizes profits at the expense of others and minimizes costs as well as the port manager. Contrived pay structures are worthless. A better example would be a port manager payed on shipping volume. He has no concern on what comes in, what comes out, or what happens in the mean time. He just offers the cheapest price regardless to get volume. He’s also subsidized.

    Sorry Yves, but this example is bunk. The solution only makes sense if you want a regulated industry. I take no subsidies over regulation any day. Then we may get efficiency. I think you hint at that, but no expert ever offers the no subsidy solution. They only blast neo-liberals who are not willing to cut subsidies either. Regulatory arbitrage is capitalism in action.

    I’m not a troll, just spending a Sat on NC. Thanks for all your posts.


    1. DanJS

      In your example, how would containers on hand be classified as “stock inventory”? The shipping company is selling transportation services, not shipping containers.

      The containers are only necessary to contain customers’ goods while enroute to destinations… otherwise, all rental or acquistion expenses and associated “warehousing costs” (to include the dock space necessary to store the containers until use,) is a “drag” on the profits of the business and its stakeholders.

    2. James Cole

      If we recharacterize the imaginary line separating individual from corporate assets and liabilities as a “subsidy” and then remove it (i.e., pierce the corporate veil across the board and for all time), we have a properly incented system. The current system is inherently distortive.

    3. attempter

      I think you hint at that, but no expert ever offers the no subsidy solution.

      That’s because the experts may think they want “reform”, but they’re unwilling to abolish the finance sector completely. Since they know that only aggressive government redistribution enables the big banks to exist at all, it follows that they have to support the subsidy regime and look for their phony solutions elsewhere. Paul “Goldman-Sachs-is-bad-for-America-but-we-still-have-to-bail-them-out” Krugman’s a textbook case.

      These solutions are, of course, phony. We know by now that corporate rackets cannot be reformed. They can only be eradicated.

    4. Yves Smith Post author


      Wow, do you have reading comprehension problems? The manager of port operations were keeping too many containers on hand because they were effectively a free good and it was happening on a scale that it was tying up a lot of capital at the client. I tell you a fact set that actually existed and you deny it. Sorry, buddy, just because it doesn’t fit your prejudices does not mean it did not happen. Clients are not in the habit of paying McKinsey big bucks for imaginary issues.

      The tone of your post is out of line. We’ve mentioned the partnership option, which has some elements of a “no subsidy” solution. That is simply not going to happen. We’d need to give up market based credit. We are not putting that toothpaste back in the tube. We’ve also discussed at length regulating banks as utilities, that’s mentioned in passing in the post. That’s as good as we are likely to get, and even that would take another crisis and a lot of will to take place.

      And your reg arb comment is industry propaganda. The Fed or the ECB could enforce global standards by denying access to their payments systems. The private systems sit on top of facilities run by the central banks. There is no way for the banks to innovate around that, an no global bank could afford to lose direct access and go through correspondent. This is a function of central banks being captured by the industry, not of doability.

      And there is no “no subsidy” option here. We don’t let banking systems fail. That’s a decision reached long ago not just advanced but also emerging economies. That line of thinking is sheer fantasy.

    5. Ming

      Scott, you are missing the point. If you set the right incentives and disincentives, and actively monitor and administer to te system, you can focus people’s thinking toward achieving what is good for the company and/ or the people. The objectives must be balanced in order to achieve what is optimal for the Short and longterm objectives of the company, and people must be measured agains the the potentially contradictory objectives I. E in this case on time shipping ( which requires that containers be available to match demand) vs minimal container stock. In the bankers case, objectives incentives and severe penalties must be developed to balance the banks need for profit, the ididividual’s
      desire to maximize their bonus, and societies need for a stable, trustworthy, and effective banking system. (often the actions
      necessary to maximize short term profit will contradict the required attitude and actions necessary to be stable and trustworthy).

      1. attempter

        How do you “set the right incentives and disincentives” for organized crime? It sets its own incentives, by its nature.

        You either tolerate it or you don’t.

  3. Pied Cow

    My suggestion for how to make bankers pay for crises is (1) investigate the crisis fully, (2) assign responsibility where appropriate, (3a) allow insolvent banks to fail, (3b) confiscate ill-gotten gains, (3c) hold people criminally responsible when warranted.

    In a word, bankers shouldn’t be treated differently from anyone else — unlike the preferential treatment they’ve given recently.

    1. DownSouth

      I agree.

      The questions is: How do we get there when the entire political sytem is owned—-lock, stock and barrel—-by the criminal bankers themselves?

      We are going to have to relcaim our political system before any real change can be forthcoming.

      1. Steve (since there is another Steve, I'll be Old Steve from now on)


        Are you in favor of eliminating or reducing dramatically deposit insurance schemes?

        Doing do would presumably limit banks’ sizes and weaken the connection of the State to the banking institutions?

        1. Ming

          What us your goal for eliminating or reducing deposit insurance schemes?
          I can only see it as making banks less trustworthy for ordinary cicitzens to deposit their money. Good for manufacurers of homebased vaults.

  4. DanJS

    Your ideas are right on. As a suggestion, and supplemental to your idea of a “fund set aside,” pass a law that requires the bankers to “establish a ‘public trust’,” into which all “banker bonuses” be escrowed for 3-5 years.

    At the end of the escrow period, make rolling disbursements to the “beneficiaries” of the trust with the requirement that all disbursements be adjusted based on current “actuarial assessments” of the solvency of the bank that paid out the “bonuses.”

    As to the holder of the “non-interest-earning” escrow accounts, neither the Federal Reserve, the banks nor wall street firms shall be allowed to “benefit” from these “fractional reserves.”

  5. ambrit

    I didn’t know, when I started lurking around the NC site that there’d be homework! (Would you accept as an excuse that the Market ate my homework?)
    The above ideas about a Financials Withholding Tax are feasable, but, considering all the discussion about ‘Regulatory Capture’ I see, the problem has to include the financing scheme for the regulators as well.
    The “Markets,” being comprised of fallable fiends after all, will always incorporate games playing actors, bent on narcisistic profits. (I know, I know, but consider; if ‘they’ can repeal Glass-Steagal, I can repeal ‘The Rules of Style.’) Hence, Regulation will always be necessary. So, I suggest, (and the ‘revolving door’ policies of Wall Street and The Hill support,) that Financiers and Regulators be treated as Symbiotes. Tie the compensation of both to the ‘Financial Withholding Tax.’ Then, as in ‘enlightened’ countries, not only will the Whores be more easily identifiable, but you can see their health cards too.

  6. Siggy

    Your solution implies that the managers who created the problem will be left in place. The driving incentive should be removal as should the driving incentive against profligacy be the right of failure. If the enterprise fails, it should be allowed to die and its former managers relegated to other employment.

    The business of the interconnectedness of the financial services industries is proof of the necessity of reconstituting Taft-Hartley. What is required is the recognition that the acceptance of the concept TBTF is itself a profound failure.

    There are now five banks that control the US financial markets and a mere five or six foreign instititions who now control the foreign markets. The existance of these dozen of so institutions is the symptom of a massive concentration of financial power. If you want fair markets, this defacto cartel must be broken up.

  7. bill mccullam

    Back in the bad old days, pre-1933, not only officers of banks, but also members of the board were personally liable. I suspect there was no limitation. Some, like Cyrus Eaton, hid their money away (and skipped the country) where the examiners couldn’t seize any of it. Others may have gone to jail.

  8. Norman

    Criticism, but I’m not a troll? A good back & forth doesn’t need that sort of clarification.

  9. Steve Bradley

    I think there are a few factors involved:
    1. Let the INVESTORS take a haircut. The buyers of bonds, etc. (I know, read pension plans) will be more cautious when they know that the banks can’t simply transfer wealth from the Federal Gov’t to them. And yes, I know that the investors HAVE taken a haircut. It’s just not enough.
    2. This is fantasy, but we need somehow to de-couple the interests of banks and the federal government, through some sort of restructuring or restricting of the Federal Reserve. In 1998 (the real seed of our 2007 crisis was sown here and before), the Fed essentially “rescued” a particular sector of the economy. The fact that it was ALSO a financial sector is largely forgotten.
    3. Stop the leveraging. I well remember in 2003 (so much for a 3 year lookback), I sat in my office in my little mortgage company watching Fannie & Freddie move to a 40-1 leveraged position. This was considered “safe.” Then 100-1 was considered safe. Even in good markets, we had a default rate greater than 1%. Since we relied on private investment (100% capital risk), we didn’t participate in that market in any way. Of course, when the crisis occurred, we got crushed along with the juggernaut that was falling housing prices, caused, in effect, by rising housing prices, caused by overleveraging in the lending markets….
    Leverage should be no more than the highest potential default rate (in other words, all new loans need to be about 80% loan to value–the 13+% current default rate plus 7% for sales costs. This, of course, disregards carry costs, but 80% is a sound number–or 75%–and that needs to be the “skin in the game” that banks are required to contribute, and hold until the loans pay off). I realize that this is insanely draconian, but this would greatly enhance the banks’ desire to fund performing loans.

  10. Rahul Deodhar

    I think the idea is valid unlike what few comments suggests.

    The size of the solution does not seem proportional to the size of problem but often marginal change in incentive structure will create a more stable system than otherwise. So I agree with the solution of clawback of X years.

    I would like to highlight that we might need more such measures. For example, the bargaining power of shareholders of banks needs to be beefed up as compared to the management.

    One way is to make conventional shareholders more responsible. There should be a mechanism to insist on additional equity from current shareholders in times of crisis. So, in effect, there is a crisis clause for shareholders too. This will possibly require bank shareholders to be pre-qualified by certain mechanism. For example, we may say the top 50% of shareholders of banks will have to contribute equity at times of crisis.

    A second possible way is to create a shadow equity of central bankers. This equity will have same rights or more as traditional equity without investing any capital. They will have nominated board member (sort of observer role) and information will be shared with all central bankers of the countries in which the bank operates. Now I know this needs work and proper ring-fencing of rights and duties but such a concept needs to be explored.

    Overall, I think we need a series of small measures creating correct incentives to deal with the crisis.

  11. Independent Accountant

    I have been screaming about the role of incentives in finance and the “classical agency problem” for over 30 years. So far, nothing has changed. Dodd-Frank will change nothing either.

  12. anon48

    Does the employer withhold part of the incentive compensation (aka deferred compensation plan) or are the employees allowed to receive all compensation each year and then be required to kick part back after a crisis has arisen?

    Is there direct relationship between the amount of comp-at-risk and the level of prior years’ transaction failures/losses that arose as result of the direct participation of a particular financial institution or employee?

    Or will this penalty be spread over the entire industry via a transaction, volume or risk premium surcharge?

    What oversight agency will be charged with making the call that a crisis has actually occurred?

    It seems that this suggestion might be more practical and effective if it were to be assessed at the transaction level rather than at the industry level. Otherwise I think it could be somewhat effective as a plan B or C that supplements an as of yet to be determined aggressive set of regulatory oversight and enforcement procedures.

    (Hopefully, you haven’t thrown in the towel on the chance of an increased enforcement option).

  13. John Iacovelli

    A nice thought. Of course, we already have an insurance system in place that has worked fabulously for the bankers, our political system. For a relatively small amount of donations to all political candidates each year, they insure that taxpayers pay for their greed.

  14. charles 2

    3 years clawback. This is pocket change ! You won’t get attitude change with that.
    The partnership model that you like is better : loosing a whole life of reinvested profits in a company starts to be adequate.
    This being said, you won’t stabilize the system with crafty incentives, but with structural measure that don’t depend on bankers’s judgment. The number one in the list is to prohibit maturity transformation in any form for any entity which is leverage above a small threshold (say, 2). It doesn’t mean that bank won’t go bust, but it will be orderly and non simultaneous, and it is easy to recapitalize through a debt for equity swap.

      1. propertius

        Psychopaths don’t fear punishment, no matter how painful or horrific. The psychological literature is pretty clear about that. Depending on the proportion of psychopaths in finance, drawing and quartering might have no deterrent effect at all (no matter how satisfying it might prove for the rest of us). In fact, the ultimate effect might be to drive the few non-psychopaths currently in finance out of the field altogether (assuming, of course, that there are any left).

  15. river

    As an engineer, I kind of like the whole licensing agreement idea where you need a special license in order to be in charge of anything important, and if found to be at fault of something big, like in the failure of the entire financial system, you would be personally liable and you could lose your right to practice. I am always appalled at all the statements about how it isn’t illegal to be really dumb, so we should let Wall Street of the hook. While it is not illegal to be dumb, in any other profession (that you might work a lifetime before you make what a wall street banker makes in one year) it makes you personally liable.

    Ritholtz had some ideas about it here I believe:

  16. F. Beard

    I’d say its hopeless because banks are:

    1) Unjust providers of money – the poor need not apply for loans.
    2) Non-optimum providers of money – usury is mathematically unsustainable.
    3) Unreliable providers of money – too much during the boom, too little during the bust.

    Surely a free market in private money creation would do much better should we ever decide to have one.

  17. lambert strether

    The question isn’t how to better incentivize the financial sector (bandaid; cancer). The question is whether the financial sector is more trouble than its worth; I’d argue yes.

    Why not turn the banks into regulated public utilities? And if the uber-wealthy want to lose their own personal cash money by playing the ponies, let ’em do that all on their own.

  18. Fox Unt Henhouse

    Obama’s National Security Advisor Tommy Donilon spent the decade prior to joining the White House as a legal advisor to powerful interests including Goldman Sachs and Citigroup, and as a lobbyist for Fannie Mae, where he oversaw the mortgage giant’s aggressive campaign to undermine the credibility of a probe into its accounting irregularities, according to government reports and public disclosure forms.

    Thomas E. Donilon had been formally advising Obama on national security matters since the president’s transition to the White House. – ABC

  19. Tom Hickey

    This is a variation of the partnership model that should never have been abandoned in banking and finance in general.

  20. Susan Truxes

    The banks are already a little too removed from the consequences of their actions. To incentivize them with delayed rewards if they are good and delayed punishment if they are naughty might be a tad too vague for bankers. What would Pavlov do? Poke them with a cattle prod or give them a cookie. There is no way to deliver this sort of reinforcement in a timely manner. Lets just nationalize the banks and go from there as best we can.

  21. Fraud Guy

    “…we maintain the fiction that major capital markets firm are private sector companies.”

    One of my favorite under-discussed examples of this reality is private equity firms. Their principals talk a big game of free enterprise, but the reality is that the vast majority of the capital they invest, and that pays their fees, comes from government LPs (public pension funds and sovereign wealth funds). They are as bad, if not worse, than any pubic utility in terms of their incestuous relationship with government.

  22. vlade

    Unlimited liability partnerships, with first claim on any and all funds and benefits to the partner and his family, unto the third generation.

    Or limited liability based on liable-until-proven-otherwise.

  23. Sauron

    Just get rid of the entire private, for profit, banking system altogether.

    There is a public bank. You need 100 000 for a house. They look at your ability to pay, set a schedule for repayment, and loan you the money, and charge you a small paper-shuffling fee. No interest is charged because the object isn’t to make a profit, it’s just to provide credit.(Although payments will need adjusting for inflation.)


  24. alex


    There are too many people detracting attention from potentially useful actions by coming up with needlessly clever (and ineffective) “solutions”. Why bother? Are they trying to prove their cleverness, their fealty to the “market oriented regulation” ideology, or both?

    The fixes were figured out long ago. What happened is that the old (post-GD) rule book was thrown in the trash while trumpeting absurd excuses about how “things have changed”. Sure they changed – they became more corrupt and irresponsible. The last time the fundamentals changed was during the commercial revolution of the 17th century.

    The analogy to the port managers is poor. First, the number of containers they keep around is directly under each port manager’s control, while he stability of the banking system is not directly under under any one banker’s control. Moreover no port manager ever got rich by keeping too many containers around. It’s a small problem that can be fixed by creating a small disincentive.

    Start throwing around billions though and it’s another story. There will always be gamblers, and hence people willing to gamble billions, even of their own money. But banking (as in basic deposit and loan operations) should be a dull boring affair that would have anyone with the soul of a gambler contemplating suicide rather than endure another day at the office. The only way to ensure that is with serious government imposed party-pooping regulation. Move over Joe Stalin – the FDIC is going to check over your books! It worked great for years, and the only thing that’s changed is the brain-washing about what’s effective or reasonable.

    If you’ve got the soul of a gambler then get thee to start-ups, VC operations and the like. There are reasons why those things are handled through equity rather than debt. The first rule of any game of chance should be put your money on the table before placing your bet.

  25. Cathryn Mataga

    Don’t wait for a crisis. Do the books right now. If TBTF bank is insolvent, zero the stock and nationalize. Run as a public utility with public utility-like wages. Spin off ‘small enough to fail’ banks to rebuild the economy.

    As for incentives, it should be a crime for bank employees to heap risks on bank balance sheets to enrich themselves. Write this law carefully to avoid any of the ‘well I was stupid’ defense. Include organized crime like provisions, so if a piece of a bank is bad criminal, that everyone goes to prison all the way from the bottom to the top. You were in the same office — it’s presumed you heard about it, you go to jail too.

    Why does this have to be so complicated?

  26. litesout

    How about just making the banks hold sufficient reserves for the loans they originate?


    How about ending the mortgage backed security? This will force banks to consider more seriously who they lend money too and how much they lend to them. I recall in 1985 taking a personal loan for $2500 was more involved than the mortgage i took in 2004.


    How about requiring banks to hold loans greater than some threshold on their books for 1/3 of the term of the loan?

    I don’t like the proposed scheme. Just make sure the lending instutions need to be extremely concerned about the risks involved in the loan origination. If i had my druthers, I’d like to go back to the old days when there were no MBS and Banks held the loans for the duration, or if they sold it the sold them to another bank.

  27. Alex

    Worth thinking about, I guess, but it ignores the regulatory capture you have documented so well at other times on your site. There will be no accountability for the people responsible for financial meltdowns as long as they are the de facto leaders of the nation…

  28. jbmoore

    I believe that we would have to repeal the Citizen’s United US Supreme Court decision first. Then, we would have to reform campaign funding and lobbying next. Glass-Steagall would need to be reinstituted. While your idea is sound, it is only a starting point. It doesn’t go far enough to prevent erosion of standards due to Gresham’s dynamics if foreign competitors cheat and steal since US firms would eventually be forced out of international markets. Any company doing business in America would have to create a risk pool or obtain insurance akin to FDIC insurance to guard against runs. If any company is guilty of committing fraud and other criminal acts in the US, or overseas even, it loses it charters and licenses in this country and the officers being culpable for those acts would also serve time even if the crimes were not committed in the US. They could be extradited to the countries the crimes were committed in. No more allowing the firm to pay fines and the perps walk away rich. Banks would need to be broken up and a ceiling of $10 billion dollars in assets and liabilities be allowed. Partnerships could be reintroduced into the banking system to ensure officers are more responsible. Derivatives with no useful purposes should be abolished. Transaction fee taxes could be levied and scaled to eliminate “virtual” financial instruments that are created solely to generate fees. Greater transparency should be instituted by requiring that contracts and disclosures can be understood by someone with a high school education and they should be as short and succinct as possible.

    1. F. Beard

      Government backed banking however “prudent” you make it is still based on theft (of purchasing power) and thus will prove to be unstable whatever your precautions.

      God is not mocked however much one tries.

      It would not be very difficult to have a completely ethical money system. But who believes that ethics are profitable?

      1. jbmoore

        These are manmade problems and will only be solved by men. This goes for finance and economics. Government is the only check we have against banking monopolies, and we better take government back from the corporations, or we’ll be virtual slaves working and enriching corporate officers instead of ourselves. Government is a subset of society and with our taxes we buy civilization. No organization is inherently evil. It’s the people in charge who make it moral or immoral and that goes for corporations as well as government. One can argue that business is inherently amoral, but that argument assumes that the product you sell to your customers benefits them and the transaction is a win:win. If you sell a person a fraud, you’ve crossed the line from amoral to immoral.

        1. F. Beard

          No organization is inherently evil. jbmoore

          Not true. Government backed banking is inherently dishonest. It allows banks and the so-called “credit worthy” to steal purchasing power from all money holders including and especially the poor. Theft and oppression of the poor are generally considered wicked and are certainly forbidden in the Bible.

          1. jbmoore

            Churches and temples are inherently dishonest by your reasoning because individuals do not need to talk to God within a sacred structure or need a priest or rabbi to intercede for them. People only need to look in their hearts to find God. Yet, we have a multitude of churches and temples, and quite a few predatory holy men. Churches and temples are not inherently evil. It is men that make them so. If sacred organizations can be corrupted, then government can be as well, but they didn’t start out that way. Government was created to protect farming communities from predatory tribes like the Hebrews thousands of years ago.

          2. F. Beard

            I am not attacking government; I am attacking government backed banking which is fascist on its face since it is government privilege for private interests.

        2. F. Beard

          If you sell a person a fraud, you’ve crossed the line from amoral to immoral. jbmoore

          Banking is a fraud; it creates and loans out money for interest that does not exist; it thus creates an impossible contract in aggregate. The interest for loans must come out of someone else’s principal thereby gauranteeing some defaults or from further loans thereby gauranteeing endless debt.

          Our banking and money system could only have been invented in Hell.

  29. Benigna Vilma Merche

    I haven’t checked in here for a while since I thought it was getting boring, but the last several posts are really great quality so I guess I’ll add you back to my daily bloglist. You deserve it my friend. :)

  30. rps

    “Is there any reason why the American people should be taxed to guarantee the debts of banks, any more than they should be taxed to guarantee the debts of other institutions, including merchants, the industries, and the mills of the country?” Senator Carter Glass, Author of the Banking Act of 1933

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