Banks, Bonuses And BankSlaughter: How To Make European Banks Less Dangerous

In trying to make the banking system less dangerous, European and global regulators are trying three approaches. First, they have just undertaken stress tests. Second, they have specified new requirements for the banks to hold more capital and fewer risky assets. Third, they have tried to weaken the incentives for frontline dealmakers to expose their firms to risk, whether by capping the ratio of bonus pay to fixed salary, or by linking bonuses to the longer term fortunes of the bank. None of these approaches is likely to work beyond the short term. Meanwhile, the British Parliament has passed legislation which gets to the heart of the problem. The rest of Europe should adopt it.

The stress tests will work in the short term to increase confidence in the banking system, (which was probably the intention). However, if system stability is the objective, the key time for stress tests is when banks are overflowing with confidence, rather than when they are hyper-cautious after having already burnt themselves, as now. What would be more reassuring is to know whether, had these tests been conducted in 2005, they would have revealed the extent of the danger? If they would not have done so then they are useless as a mechanism for long term stability. But if they would have done so, this raises an equally troubling issue: why were they not undertaken? The most credible answer is quasi-political: in times of over-confidence a combination of complacency and fear of revealing weaknesses keeps troublesome messengers at bay. Is next time really likely to be different?

The requirements for higher capital relative to risky assets, if effective, may further deflate Europe’s submerging economies as banks reduce lending. By reducing GDP, this would shift the risk from the banks to government indebtedness. The ECB is trying to offset this by itself becoming a quasi-commercial bank. Whether this package works in the short term, it risks being undermined in the long term. Banks may invent ingenious ways of getting the risks off their books. After all, their lawyers are paid at least ten times what the regulators earn, and this is what happened last time. With risks in the shadows, they would be increased, not reduced.

The assault on bonuses is understandable from the perspective of inequality, but is based on a naive view of incentives. If the ratio of bonuses to salary is capped, managers will find it a little more difficult to motivate staff to work hard. However, they would still have salary increases and promotions as incentives, and if these are insufficient and work effort declines, they will simply need to hire more, but cheaper, bankers to get the same deals done.

If bonuses are deferred and linked to the future performance of the bank, will this discourage individual bankers from doing risky deals? Not one whit. To imagine that it would is to confuse individual with collective incentives. Collectively, bankers would indeed have an interest in the longer term success of their bank, but individually they would still have no control over this outcome. By doing a risky deal which was profitable in the short term an individual banker would get an entitlement to a bonus, as now, though whether it is paid out would depend upon the deals which the bank’s entire workforce struck. Since the individual banker has no control of this collective outcome, individual incentives would not be altered.

Five years ago, in an article for The Guardian, I proposed that the only way in which the risks of bank failure could be effectively addressed was to change the criminal law. It is an astounding fact that no senior banker anywhere has been successfully prosecuted for the behaviour that produced the financial crisis. The reason for this failure is straightforward: it is virtually impossible to prove that senior bankers intended to bankrupt the organizations for which they were responsible. I argued that what was needed in banking was the equivalent to a legal distinction we already make in prosecuting the responsibility for a death: that between murder and manslaughter.

Conviction for murder requires proof of intent; conviction for manslaughter only requires proof of recklessness. Self-evidently, some senior bankers were reckless: we need the offence of bankslaughter. Only if they can be dragged from their retirement on the golf course and jailed will the present generation of senior bankers do ‘whatever it takes’ to keep their banks sound. Fussy regulation shifts responsibility from managers to regulators: managers merely have to tick the boxes. Once managers face the risk of jail, they will figure out how to redesign reward systems so as to discourage staff from doing dangerous deals.

Remarkably, this is the legislation that the British Parliament has just passed. Its efficacy has been demonstrated immediately. Two main board directors of banks have resigned rather than face the responsibility of running their banks prudently. Such changes in people and cultures are precisely what are needed to prevent a repeat of history.