Bad banks are back

Like one of those movie monster franchises, the spectre of bad banking has returned to haunt the widescreen of the global financial sector. Readers might have thought the greatest economic crisis since World War II had killed off the pinstriped zombie brutes who threatened to consume the international financial system and much of the productive sector with it.

But no; they're back and greedier than ever. Complex debt derivatives are once more on the menu, risk-taking and financial innovation are again part of the broad banking discourse and the return of astronomical remuneration packages is but another slap in the face of an appalled public, whose tax dollars bailed out many of these institutions. Commentators, politicians and banking regulators are rightly concerned.

As a recent paper by Lucian Bebchuk and Holger Spamann, professors at Harvard University, spells out, the leveraging of bankers' incentives played a large role in creating this awful mess from which we are only now emerging.

Traditionally, executive interests should be aligned with those of shareholders, but not necessarily so with banks, argue Bebchuk and Spamann. Shareholder interests may well be best served by banks pursuing riskier strategies, even though these are potentially detrimental to the interests of government, the wider business sector and taxpayers when everything implodes, as it did.

Usually, bankers and shareholders can expect to "benefit more from large gains than to lose from large losses of a similar magnitude,'' they explain, which is why bankers took the risks that spawned the crisis.

Bank executives have not borne financial losses of the same magnitude as their actions created. They were shielded from the subsequent fallout by compensation arrangements such as Merrill Lynch's awarding of US$3.6 billion in bonuses ahead of its US$15b loss and subsequent purchase by Bank of America. 

"We argue that they [the banks] had incentives to take risks that had both an upside and a downside, and that were socially excessive yet privately optimal.''

Shareholders, too, are captured by the special moral hazard that banks present: "Those who provide (equity) capital have an excessive incentive to take risk. They will capture the full upside but some of the downside will be borne by the government as insurer of deposits if the bank goes bankrupt.''

So it proved, although in New Zealand it is only in the finance company sector that government insurance has been applied to institutions that otherwise would have gone bust.

Bebchuk and Spamann use the common non-banking activity of hedge funds as an example of excessive risk and return. The bank's strategy is aligned to the fund's and when the latter loses money, the bank books a loss of equity. But common shareholders of the bank's holding company lose nothing as the bank's assets are protected from any losses the fund incurs.

If the fund succeeds, however, they share the profit. Executives, who are mostly common holding company shareholders, are encouraged to pursue excessive gain, irrespective of the potential loss. Bankers are, Bebchuk and Spamann say, "willing to literally bet the bank for a penny'' as the capital structure insulates them from the loss of value in bank assets. Stock options, a ubiquitous element of bank remuneration, further queer the pitch.

"The executive's calculus will not be the same as that of the common shareholders of the bank holding company because he or she will fully capture [future] gains in stock price but will not fully bear the losses as common shareholders would.''

How close did the world come to disaster? Following the Lehman Brothers failure, Federal Reserve chairman Ben Bernanke was asked what would happen if he and the government did nothing. His reply: "There will be no economy on Monday.''

Bebchuk and Spamann say the risk-taking incentives remain, despite the carnage: "They simply have less to lose from making bets.'' Incentives matter, they say, particularly given the cost to the taxpayer.

They want central banks to start monitoring the pay arrangements of bank executives and even prohibit certain traditional components of remuneration "as part of their overall risk monitoring''.

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Justice   #1   09:05 pm Sep 04 2009

Nick, ask Mr Bollard if he's concerned? Bet he isn't, Why? Because the Reserve Bank is head crock! The RB wants to have its cake & eat it also, which is what the main street banks want also, so any conflict between the too is "just for show". Why does no one in the media comment of the currency dabbling the RB do in relation to the NZD? The RB has been helping to keep the NZD overvalued now for more than 6 years at the expense of our exporters! Why do they get absolutely no criticism for this?

Sam   #2   03:14 pm Sep 05 2009

Maybe Moderate bonus packages enough by way of regulation to the point where the incentive is still there for the executives to perform well and the shareholders are kept happy.

Charlie   #3   10:38 am Sep 07 2009

Practically all bankers did not realise the risks they were taking. Instead of experience, common sense, and a knowledge of history they relied on the pseudoscience of quantitative risk management. They may as well have relied on astrology.

justice   #4   08:57 pm Sep 07 2009

Charlie, surely some did? they just got so greedy they were blinded by their own faith in a totally bogus system that if they had done ANY research about the 1929 crash they would of thought they were watching "Groundhog Day" with Bill Murry

Charlie   #5   11:03 am Sep 08 2009

justice #4

No bank management are pretty much all "can't do maths can't do languages" types who had to go into commerce because they did not have a hope of getting into medical school or similar. Although they may have plenty of low cunning and be skilled office politicians fundamentally they are all as dumb as a box of rocks.

paul   #6   01:03 pm Sep 08 2009

Banks in New Zealand don't operate in the same way as banks overseas (at least not since the 1980's) so it would take a lot more than a financial crisis of a far greater magnitude than the last one to bring any of the major trading banks in NZ to anywhere near the brink of collapse.

It's why we pay such huge fees on everything.

justice   #7   09:20 pm Sep 08 2009

Paul, if your paying "huge fees' then change banks or atleast threaten too. Overseas banks charge for everything also EXCEPT alot of them do not charge you an ATM fee. Anyway back to your point about the financial crisis, OUR banks are just as affected due to their huge borrowing from overseas banks. Westpac borrow a load (billions)from HSBC and other huge banks. Luckily HSBC being an asian based bank got through the crisis not to bad, I think they lost 2-4 billion in all. Better than being insolvent i guess. My point is our banks must still be vigilant, hence the high fees to customers. If NZ mortgage foreclosures gets worse there is a good chance one or two NZ(aussie) banks) might need a government top up at some point. We have a long way to go yet in this crisis, The REINZ might think it's all but they ofcourse would love it to be over or atleast have us ALL believe it is.

steveusa   #8   05:10 am Sep 09 2009

Kiwi banks are run by Kiwis with conscience + distance to USA which keeps them relatively sound American banksters/Wall Streeters are addicted to a drug called "money"

how would you like your banks (and many if not most of your major companies)run by drug addicts?

...and our "captains of industry" are still riding and getting HIGH

Alan Wilkinson   #9   09:42 pm Sep 09 2009

A nice article in the Times by Rees-Mogg puts this issue into better perspective:

http://www.timesonline.co.uk/tol/comment/columnists/william_rees_mogg/article6824030.ece

paul   #10   09:15 am Sep 10 2009

@justice #7

I changed banks 15 years ago - and don't pay for anything.

Westpac and other NZ banks didn't engage in the same kind of lending as overseas banks. Unlike say Deutsche Bank, NZ banks did not buy over inflated debt secured against trashed houses in Alabama.

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