To understand both why the banks didn’t go further on their own and why the threat of regulation helped things along, even before the rules were agreed upon, it’s worth consulting a famous essay from 1973 by the social scientist Thomas Schelling, written on the subject of hockey helmets. At the time Schelling was writing, the N.H.L. had yet to require players to wear helmets, which had been around for decades. Players were allowed to wear them, but the vast majority did not, even though this increased their chances of serious injury, and despite the fact that informal polls suggested that many players would have preferred to use them. The problem was that, while not doing so had obvious costs, it also had perceived benefits: a player’s peripheral vision was slightly better, for one, and it conveyed a sense of toughness. As a result, players tended to believe that anyone who wore a helmet was, in effect, hurting his performance relative to everyone else on the ice.
.. Bonus clawbacks, for example, reduce the chances that bank employees will take foolish risks or engage in fraud, and so would seem to make banks “safer.” But banks are competing against each other for talent. And, in that competition, any bank that insisted on clawbacks would be at a disadvantage. Even smart traders or executives can make bad bets in financial markets. So, all else being equal, prospective employees would almost certainly opt for a contract that didn’t include the threat of clawbacks over one that did.
.. This is the paradox that Schelling’s essay exposes: sometimes, having your freedom restricted makes it easier to do what you wanted to do in the first place.
What Would Breaking Up the Banks Even Look Like?
A too-big-to-fail, too-complex-to-manage bank such as JPMorgan Chase should be split into three parts. The investment bank could be spun off entirely. JPMorgan’s creative investment bankers would relish the chance to turn the franchise into a partnership, with the freedom to pay themselves what they please. The remaining bank would be split into a wholesale bank, for large corporate clients, and a retail bank, the only taker of insured deposits.
.. The investment bank would be regulated as lightly as a hedge fund, but would not have access to financing that uses taxpayer money. The wholesale bank would provide only simple banking products, including foreign exchange and interest-rate hedges. The retail bank would be limited to consumer banking and small-business and mortgage lending, with no scope for high leverage or the big-scale securitization that sank otherwise simple banks, such as Washington Mutual, in the crisis.
.. Just as important as a structural change is the need to eliminate the culture of bonuses at consumer-facing banks.
.. The bonus pool would skim off 40 to 50 percent of revenues up-front while any losses hit only shareholders and taxpayers.
.. In my view, when banks have access to central-bank funding there should be a legal limit to what they can pay their employees ($500,000 a year wouldn’t be unreasonable).
.. In my view, when banks have access to central-bank funding there should be a legal limit to what they can pay their employees ($500,000 a year wouldn’t be unreasonable).
A Better Way to Control the Banks
What gets lost in the discussion is that Dodd-Frank, properly executed, would help to create the conditions for breaking up large and complex banks. That’s because the banks would face rising regulatory costs, which means they might well be worth more to investors if taken apart.
.. Even so, the capital requirements are not strong enough, in part because they do not require banks to fully account for potential losses from the trading of derivatives, a multitrillion-dollar activity.
Recent data provided by the banks to the Federal Reserve show that capital at big American banks recently averaged a healthy 13 percent of assets. But if derivatives and other holdings were fully included — as is required under international accounting rules but not under American ones — capital would come to a feeble 5.7 percent.
We were better served by old-fashioned relationship-focused bank managers
Banking was then a career for those who did not quite make the grades required by the good universities. If they joined either of these two institutions, they might with diligence become branch managers after 20 years. The bank manager was a community figure who would base his (they were all men) lending decisions as much on his local knowledge and the character of the borrower as on figures. He expected to spend his career at the bank and retire with a generous pension to spend more time on the golf links where he had schmoozed his clients. It never crossed his mind, or those of his customers, that the bank he had joined would not continue forever in broadly its existing form.
.. Lawrence Summers (the former US Treasury secretary who experienced the transformation variously as academic, politician, university administrator and would-be central banker) described it thus: “In the last 30 years the field of investment banking had been transformed from a field that was dominated by people who were good at meeting clients at the 19th hole, to people who were good at solving very difficult mathematical problems that were involved in pricing derivative securities.” Professor Summers reported this shift with evident approval.
Yet these cleverer people managed things much less well than had their less intellectually distinguished predecessors. They were rarely as clever as they thought they were — or sufficiently clever to handle the complexities of the environment they had created.