Guest post: Why regulators should focus on bankers’ incentives
I contend that the regulatory failures that led to the crisis and the shortcomings of regulation since are largely derived from a failure to identify the persons responsible for bad decisions. Banks cannot take decisions, exhibit behaviour, or have feelings – but individuals can. The solution lies in reforming the governance set-up and realigning incentives faced by banks’ management.
Recent regulatory problems have been greatly reinforced by a widespread tendency to apply human characteristics, i.e. to anthropomorphise, to an inanimate institute, in this case a bank. We tend to talk about Bank X having assumed too much leverage, or having behaved in an improper fashion—rather than management of Bank X did such and such; We say that Bank X got bailed out rather than the creditors and clients of Bank X got bailed out.
.. When bad behaviour occurs at a lower level, e.g. traders conspiring to rig Libor, or junior employees mis-selling products onto uninformed customers, should managers, directors and CEOs be able to shelter behind the fact that they did not know what was going on? Should they, could they, have taken steps to find out? There is surely a case for reversing the burden of proof. Each manager should be held responsible, and subject to suit, unless they can demonstrate that they took all reasonable measures to oversee and to constrain the actions of their juniors.
..We would be told that such measures would make banks unduly risk averse and prevent qualified bank managers going into the profession. Where is the evidence for that? Banking worked on the basis of unlimited liability up to the second half of the 19th Century, and banks then took plenty of risks.
.. Avgouleas and Goodhart argue that history shows that when a bank’s difficulties reflect broader macroeconomic problems rather than bank-specific issues, imposing haircuts on creditors of one bank is likely to accelerate panic and risks contagion to other institutions, which may require public funds to shore up the system as a whole.
.. If, instead, incentive structures were changed to impose appropriate penalties for failure on the banker, then bankers would themselves choose whatever structure, perhaps smaller and simpler, would provide them with an acceptably reduced chance of failure.
.. Managers on the spot will have a better idea of what they can safely undertake, than illustrious independent outsiders.
.. If a bank CEO knew that his own family’s fortunes would remain at risk throughout his subsequent lifetime for any failure of an employee’s behaviour during his period in office, it would do more to improve banking ‘culture’ than any set of sermons and required oaths of good behaviour. The root of the problem is the bad behaviour of bankers, not of banks, who are incapable of behaviour, for good or ill. The regulatory framework should be refocused towards the latter, with a focus on reforming incentives.