Accountability in Banking - It's all about the Incentives

The 2007 financial crisis and the subsequent struggle to recover among developed countries have left a bitter taste in the mouths of the electorate of those countries. Understandably so. They have been left to bear the dual burden of paying to bail out those who caused the crisis, while at the same time having to struggle with a protracted recessionary environment.

Governments of developed economies have rallied around the idea of stricter regulation as the best way to both prevent future crises and punish institutions. The idea being that these governments - individually or in collaboration - will serve as judge and juror on the appropriate levels of risk for banks to be taking. If banks stick to these requirements, we shouldn't have to deal with such problems again. Or so the theory goes.

This remedy may prove adequate in the short- to medium-term, since we have a relatively good understanding now of why the 2007 crash happened. Irresponsible lending practices, coupled with absurd levels of leveraging on bank balance sheets created a situation where periods of high default were inevitable and, when it happened, banks had no margin of safety to be able to withstand it.

Understandably then, governments have asked banks to raise their capital requirements - though to lower levels than originally suggested - in order to expand their margin of safety.

Likewise, since the reason given for the fact that the banks were bailed out is that they were "too big to fail" governments have been looking into provisions which would require all investment banks to be split from commercial banks.

This strategy ignores, however, the extent to which regulators are at the whim of popular, short-term public opinion. The current political climate may be conducive to effective regulation but a brief look at the history of banking regulation, however, shows us why this approach will not work in the long-term. Throughout the history of financial markets, such regulations are inevitably eradicated by politicians lusting after increased economic growth to satisfy their electorate.

The situation of the bankers who caused the crisis is almost identical to that of the politicians who abandoned prudent financial regulations, such as the Glass-Steagal Act. They were placed in positions of enormous power and enormous opportunity, where their own personal incentives were divorced from that of their institutions.

Bankers were paid to lend en masse, not to build the future profitability of their institutions. The Presidential Administration was able to take credit for the booming economy, knowing that they would not be in office (or in the case of Members of Congress, would not be held personally accountable) for the resulting bust.

Not every banker or politician who assumes positions of power will put their own interests before the millions that they serve, but it stands to reason that eventually some will. As such, any lasting panacea for these problems must somehow align the interests of the leaders and the long-term interests of the people that they represent. For this reason, government regulation is not itself a complete solution.

As I see it, there are two ways to bring the interests of major banks into line with the individuals which run them:

1) Tying a proportion of any banking losses to the people that caused them. That is to say, whoever underwrote a loan which subsequently defaults, has a proportion of that loss taken from their own payment. This makes logical sense, since most banks already incentivise their employees for particularly profitable years. If employees share in the profits, sometimes to outrageous extents, why shouldn't they also share in some of the losses?

Of course, the problem with this approach is that corporate pay structures are typically set by banking executives (or people that they appoint) who have little incentive to set tough standards for themselves.

2) Having accepted that banks in the developed world are "too big to fail" we have inherently accepted that the public have a vested interest in ensuring that banks act in a responsible manner. That is, we have a right to regulate banks to ensure that they do not undertake unacceptably risky activities because, in doing so, they are potentially causing a significant public harm. Why then, is it not a criminal offense to cause a public harm such as the recent financial crisis?

If I were to fall asleep at the wheel of my car and kill someone I would likely serve time in prison, even though my actions were unintentional, because I took an unacceptable risk in driving when over-tired. Why are banking executives that brought a global banking system to its knees, and destroyed the lives of millions of people not held to the same standard?

Such a policy is not a witch-hunt to placate vengeful electorates – it incentivises senior banking executives to curb their risk to levels that there institutions can withstand, while leaving them free to pursue enough risk to oversee the kind of long-term profitability which is in the interests of both their institution and society.

Most importantly, for bank executives that have more money than they can ever hope to spend, and who find increasingly complex means of shielding it from the coffers of their governments, the loss of freedom is perhaps the only stick that the state can still hold over them.

Gun Laws in America - Safeguarding the Right to Kill

On January 29th, 1979, 16-year-old Brenda Ann Spencer opened fire at Cleveland Elementary School in San Diego, California, killing the Principal and Head Custodian of the school, as well as wounding 9 others. When asked why she had done this, Spencer replied, "I don't like Mondays. This livens up the day." The rifle that she used was a Christmas present from her father, legally bought and given to her. Until the moment she pulled the trigger, Brenda was yet to commit a crime.

Just as shocking, however, is the fact that this kind of incident is commonplace in a country which endeavours to be the world's conscience. It is sad that such barbaric incidents should continue to occur, unabated, for fear of inciting the wrath of the gun lobby, but they do. When Seung-Hui Cho killed 32 people and wounded many more at Virginia Tech in April 2007, in what was the deadliest shooting rampage in U.S history, the idea of banning guns was not even mentioned, let alone pursued.

What has surprised me most when broaching the subject with Americans (and progressives at that) was their response that "guns make people safer." It seems as if people have been told this for so long that it has come to be accepted as truth. When looking at the figures for gun deaths, however, this notion appears comical. If you combine the populations of the United Kingdom, Japan, Australia, Spain, Canada and Holland, all of whom have strict gun laws, you get a population which is slightly larger than that of the United States: in 2002 (the most recent year for which I could find data) the aforementioned nations had a combined total of 1,793 gun deaths, whilst the U.S had 30,694. With 17 times the rate of gun deaths it is hard to argue that guns make people safer.

The electorate's lack of education on the issue is a symptom of the problem, though, rather than the cause. It is not apathy and support for the gun lobby that has made them such a powerful force, rather it is the gun lobby systematically stamping out opposition to it in Congress which has led us to this point. In 2004, the NRA had a total income of over $200 million. This money was used to finance attack ads against candidates who favoured greater restrictions on guns and to fund "public education intitiatives" which promote ideas, such as "guns make people safer." The Brady Campaign, the NRA's largest opponent, could only dream of having such resources.

Recently, the U.S Supreme Court overturned the D.C handgun ban by citing it as "unconstitutional", yet another setback in the fight to lower the rate of gun deaths in the U.S. The Supreme Court's decision was predictable, with the current balance of the court lurching so far to the right, but disappointing nonetheless. How either Spencer or Cho represented "well-regulated militia[s]" is beyond my reasoning but the Supreme Court certainly felt that their's was a cause worth protecting. How many more must fall before people take notice?

The end of this battle is nowhere near but I can only hope that politicians will suit up for it some time soon. Debate on this issue can only be a good thing since the facts are on our side. It has certainly been a long time coming.

Washington