There are basically two ways for a big bank to do bad things:
- It can do bad things to itself.
- It can do bad things to someone else.
There is some blurring of the boundaries. The U.S. legal system being what it is, No. 2 quickly turns into No. 1 as well: If you, say, manipulate Libor, or sell someone a mortgage-backed security that is designed to fail, or whatever, then eventually you will get in trouble and have to pay big fines and generally end up regretting whatever bad thing you did. And, the banking system being what it is, No. 1 can become No. 2 as well: If you do enough harm to a bank, or more particularly to the banking system, it can blow up the economy for everyone else.
Still they are essentially different things. No. 1 is an error of business judgment: A bank can make bad trades or bad loans, just like any other company can make bad business decisions, and then it will lose money. Bad business decisions at big banks are perhaps of more societal concern than bad business decisions at tech companies or whatever, insofar as big banks are big and levered and funded by run-prone financial instruments. So you might want to regulate banks to try to keep them from making bad business decisions, and in fact we frequently do.1
No. 2 is, you know, fraud, or fraud-lite, or “the business model of Wall Street is fraud,” or some other fraud-adjacent concept. It is not unique to banks either; lots of companies in lots of industries find lots of ways to harm and deceive their customers. I suppose you could make a case that the financial industry is especially susceptible to fraud, in that its core products are complicated and somehow ethereal, but, you know, who really understands how their Volkswagen’s engine works? In any case, sure, you would probably want to regulate banks to try to keep them from defrauding their customers, and again we do.2
One loose thing you could say is that in 2008 there was a lot of reason to worry about banks doing bad things to themselves. They had all that money, and then they didn’t have it any more; where did it go? They must have done bad things to it, like invest it in risky mortgage-backed securities. And then there was a financial crisis and a recession, and regulators sensibly responded by trying to come up with ways to stop banks from doing bad things to themselves. And then the banks more or less did. There were some blips, like the London Whale, but by and large the regulatory push to make banking boring and safer has made banking boring and safer.
But that success is no reason to stop being mad at banks, because it turns out that banks also do bad things to other people, and there is still plenty of anger to go around. Some of it is related to the financial crisis — while banks were loading up on risky mortgage-backed securities, they were also perhaps misleadingly selling those securities to customers – but most of it isn’t. The Libor scandal, the foreign-exchange rigging scandal, State Street’s dumb sad scandal where it overbilled customers for SWIFT messages: None of these things have much to do with swashbuckling traders loading up on crazy risks that might put their employers into bankruptcy. Quite the reverse. Rigging Libor, or fixing FX exchange rates, reduces a bank’s risk: It turns a market risk into a known, predictable, manipulated thing. And honestly it is hard to think of a safer, or less exciting, revenue source than passing through out-of-pocket expenses to customers and adding a markup.
In some ways, those are the scandals that you would expect from boring banking: Not taking wild risks in the hope of obscene profits, but finding low-risk ways to squeeze extra money out of customers without their noticing.
Today, in a weird quirk of the U.S. financial regulatory system, the National Credit Union Administration released a new proposed rule requiring big banks to defer bonuses for four years and claw back pay from traders who cause big losses. (The National Credit Union Administration doesn’t actually, you know, regulate Goldman Sachs and JPMorgan, but there is something symbolically pleasing about it being the agency that announced the rule.3) The rule is a result of the 2010 Dodd-Frank Act, and ”regulators scrapped an earlier version of the rules in 2011 after a flood of criticism,” but there is still something somehow 2010-ish about the new rule. Its focus is on risk-taking. The rule requires big banks to hold back incentive pay for four years (with no faster than pro rata annual vesting) for “senior executive officers” (who have to have 60 percent of their bonuses held back) and “significant risk-takers” (who have to have 50 percent held back4). ”Significant risk-takers,” in turn, are employees who get at least one-third of their pay in the form of incentive-based bonuses and either:
- Are in the top 5 percent of employees by pay5; or
- “May commit or expose 0.5 percent or more of the net worth or total capital” of the bank.
The basic result is that executives, very senior managers, and traders with the power to lose money6 have to have their bonuses deferred. Most salespeople and advisers, on the other hand, seem to be more or less unrestricted. That 0.5 percent threshold is just for direct risk to the bank:
The exposure test relates to a covered person’s authority to commit or expose significant amounts of an institution’s capital, regardless of whether or not such exposures or commitments are realized. The exposure test would relate to a covered person’s authority to cause the covered institution to be subject to credit risk or market risk. The exposure test would not relate to the ability of a covered person to expose a covered institution to other types of risk that may be more difficult to measure or quantify, such as compliance risk.
The power to do bad things to customers doesn’t count — even if those bad things can come back to haunt the bank. The focus is on the risk of losing the bank’s money, not the risk of losing anyone else’s.
The rule has other parts, too. There is a general principles-based requirement that a bank shouldn’t have a compensation program that “encourages inappropriate risks” by giving anyone “excessive compensation, fees or benefits” or by paying them in a way “that could lead to material financial loss.” The people subject to the deferral rule — senior managers and significant risk-takers – would also be subject to a clawback rule, which allows the bank to reduce or eliminate any deferred bonus before it vests, and to claw it back for as long as seven years afterward. And deferred bonuses can be lost or clawed back for a variety of reasons, including compliance problems, enforcement actions and fraud. So there is some focus on harm to customers and reputational risk. But again this rule applies only to senior managers and significant risk-takers, that is, to people with the power to put the bank’s capital at risk, not to people with the power to put the bank’s customers at risk.
As a first reaction to the financial crisis, this seems like exactly the right focus. It doesn’t quite seem to fit the mood of 2016, when banks have cut back on risk-taking with their own balance sheets and when so much of their risk is now legal and compliance and operational and reputational and technological. The people who are supposed to be able to lose a lot of money for banks have mostly stopped doing that. It’s the people who weren’t supposed to be able to commit capital in the first place who are causing the headaches.
Of course nothing stops the banks from applying the deferred-compensation rule more broadly; most banks defer a portion of bonuses even without the rule, just because they think it’s a good idea7. And of course senior executives whose bonuses are subject to deferral and clawbacks might themselves pay more attention to preventing slow-burning compliance problems that might impact their own pay. And even if they don’t, well, preventing banks from taking dumb risks is worthwhile in itself, and adjusting compensation to try to change the culture of banking – from one of short-term risk taking to one that rewards years of boring, stable, prudent behavior at a single bank — is not the worst way to do that.
But the Volcker Rule and other regulatory and market changes have already made banks considerably less hospitable places for risk junkies. So much of the current discussion about banking culture focuses on concerns about a culture of fraud, and on protecting customers from unscrupulous bankers. There is something pleasingly quaint about reading this new compensation rule in 2016, with its implication that what needs changing about banking is the culture of risk, and that banks mostly need to be protected from themselves.
- Loosely speaking this is known as “prudential regulation” and includes things like telling banks not to make leveraged loans at more than six times Ebitda.
- I mean, there are just regular rules against fraud. Fraud is mostly illegal. There are also more specific rules regulating the sales and disclosure practices of banks, and sometimes those rules are even stricter than they are in other areas of business. (For instance, not a lot of industries require salespeople to disclose their markups, but the securities industry sometimes seems to be heading that way.)
- The rule is a joint rule worked out by the NCUA, the Federal Deposit Insurance Corp., the Federal Housing Finance Agency, the Federal Reserve, the Office of the Comptroller of the Currency and the Securities and Exchange Commission; the NCUA’s proposed rule text discusses the other agencies’ (essentially parallel) rules too. The other agencies will similarly release their versions; the NCUA just got around to it first.
Incidentally, I don’t know if there’s a lot of swashbuckling risk-taking at credit unions, though part of me hopes that there is. As far as I can tell there is only one credit union with more than $50 billion in assets, the cut-off for some of the specific bonus holdback rules.
- Here I am referring to the rules for “Level 1 covered institutions,” meaning banks with at least $250 billion in consolidated assets. There are slightly different standards for “Level 2 covered institutions” with between $50 billion and $250 billion in assets.
- Again, this is for Level 1 banks; for Level 2 banks it’s the top 2 percent. Also the top-5-percent calculation is more complicated than what I describe; for one thing, it’s the top 5 percent of people who get incentive-based pay, not of all employees.
- And not even that much money, because the 0.5 percent threshold is calculated very strangely. From the proposal:
As an additional example, a Level 1 or Level 2 covered institution could authorize a particular covered person to trade up to $5 million per day in a calendar year. For purposes of the exposure test, the covered person’s authorized annual lending amount would be $5 million times the number of trading days in the year (for example, $5 million times 260 days or $1.3 billion). This would be true even if the covered person only traded $1 million per day during the year or if the covered institution reduced the authorized trading amount to $2.5 million per day at some point during the year. If, however, in the course of the year the covered person received authorization for an additional $2 million in trading per day, the covered person’s authority to commit or expose capital for purposes of the exposure test would be $1.82 billion ($7 million times 260 days). The Agencies are aware that institutions may not calculate their exposures in this manner and are requesting comment upon it, as set forth below.
What? I feel like, if you’re a trader authorized “to trade up to $5 million per day,” and you lose, say, $100 million in 20 days, they’re going to cut you off. Like you’re not really going to get to $1.3 billion in exposure one limit-down day at a time. But whatever.
Incidentally, for general sizing purposes, JPMorgan’s total capital is about $237 billion; 0.5 percent of that is about $1.2 billion, or, I guess, about $4.6 million per trading day, if that’s how you’re counting for whatever reason. If that is how you’re counting, I suspect a lot of traders will be covered.
- Possibly for theoretical reasons having to do with risk-taking incentives, but mostly just as a retention mechanism: If your bonus doesn’t vest for four years, it’s hard to leave in two years.