7 ms·

Why regulators should focus on bankers’ incentives

63 points by bostik 10y ago

jackgavigan 10y ago
"Responsibility is a unique concept: it can only reside and inhere in a single individual. You may share it with others, but your portion is not diminished. You may delegate it, but it is still with you. You may disclaim it, but you cannot divest yourself of it. Even if you do not recognize it or admit its presence, you cannot escape it. If responsibility is rightfully yours, no evasion, or ignorance, or passing the blame can shift the burden to someone else. Unless you can point your finger at the person who is responsible when something goes wrong, then you have never had anyone really responsible." – Admiral Hyman G Rickover, United States Navy
Maarten88 10y ago
As long as risks are financial only, they will just get insurance against it and still get away with the current risk-taking behavior, passing the costs to the customer. Criminal punishments (jail time) might work. I think that taxing transactions in financial products would help a lot more, making the finance industry smaller, which I think would be very beneficial to society.
- maxerickson 10y ago
  If the insurance is correctly priced then the banks that don't pass the cost of risk on to customers should be able to compete nicely against the ones that try to.
  - deleted 10y ago
    [deleted]
  - winstonsmith 10y ago
    > If the insurance is correctly priced then the banks that don't pass the cost of risk on to customers should be able to compete nicely against the ones that try to. This theory breaks down if you distinguish between banker and bank as per the article. In the short term, the crooked banker with insurance can out-compete the honest uninsured banker by making high risk loans, not caring if the loans are paid back. In the short term the crooked banker can accumulate tens or hundreds of millions of dollars and happily retire when in the long term the loans fail and the bank goes bankrupt. The honest banker has to explain to his share holders etc. why crooked banker's bank is growing so much faster than his bank. His borrowers have to compete for houses against borrowers from crooked bank who can borrow more and therefor pay more for houses. His "under-performing" bank may become an acquisition target of crooked bank. The requisites for this dynamic are the absence of fear of criminal prosecution and perverse incentives via excessive CEO compensation.
    - maxerickson 10y ago
      Where's the insurance company in all this? They aren't going to sell a risky crooked banker a blanket policy that covers being crooked for nothing, they are either not going to sell a policy at all or are going to charge crazy premiums for it. Insurance isn't some magic thing that you just go get, it has a price set by well informed underwriters.
      - winstonsmith 10y ago
        Eg., AIG. The "magic" is that insurers can also be crooked, have CEOs with perverse incentives and effective immunity from prosecution, and be favored with bailouts.
- VHRanger 10y ago
  Making the finance industry smaller would not help society, because it would make lending more expensive. That would mean more expensive mortgages, more expensive loans, less VC funding, etc. Making big banks smaller also will not help socially because banks have returns to scale in diversification. So bigger banks are less likely to fail by themselves, and can lend for lower rates, which is socially good (recent research [1] [2] indicates this might not be true for the biggest banks -- they exhausted benefits of scale). Now one might ask if "too big to fail" effects might incentivize the bigger banks to act recklessly and counteract the above benefits? The answer is that there's the evidence does not back that up [3] at least for 2008 [4]. But that doesn't mean it is or is not the case going forward. Why did banks act so recklessly if they were not acting on too big to fail incentives, then? The answer, like in the OP, is management incentives. The managers could not give less of a fuck if the bank failed, because they were incentivized by shareholders, in the form of bonuses, etc. to generate large year-over-year profits. And in any market close to efficient, the only way to do that is to take on large risks. Not only did the managers not lose money if the bank failed, they didn't have any personal risk whatsoever. The lead up to 2008 was perfectly strategically rational coming from a bank manager's point of view. As the poster above me says, one way to fix that is to impose penalty from the judicial system. There's only so much financial regulation can do. But DoJ has been awful at that, even clearly criminal acts (remember HSBC?) doesn't send management to jail. [1] http://commons.colgate.edu/cgi/viewcontent.cgi?article=1053&context=econ_facschol http://commons.colgate.edu/cgi/viewcontent.cgi?article=1053&... [2] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2655448 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2655448 [3] http://fic.wharton.upenn.edu/fic/papers/11/11-47.pdf http://fic.wharton.upenn.edu/fic/papers/11/11-47.pdf [4] Remember the official fed policy was not to bailout banks coming into the crisis. They let the first behemoth fail, but quickly realized the disaster that awaited the global economy if they let the next one fail.
  - collyw 10y ago
    I was under the impression that the finance sector has shrunk since the crisis. Lending rates seem to be pretty much the same.
    - 10y ago
- zo1 10y ago
  Either way, how can we expect such reform to happen when the politicians we elect to do our bidding aren't held to similar or larger standards? They barely have "career" risks in not getting elected if a policy fails. But that's only if it fails spectacularly-enough for the media to make a big fuss over it. Most of the time, they double-down and claim "lack of funding", or something. That's their get-out-of-jail-free card.
- MR4D 10y ago
  Your last sentence is an unbelievably ignorant comment. First, what are you going to tax? Credit card use? Home loans? Business loans? Exchanging money? Debit card use? Deposits & withdrawals? Secondly, making the financial industry smaller makes the economy smaller. There is a direct relationship. So if you want to shrink it, realize that your job, my job, and everyone here on HN will have their job at risk from a shrinking economy. The financial industry shrunk in 2008, and also in the great depression. You might want to understand the cause and effect in the business before you make comments like your last sentence. There are some simple solutions to the financial misbehavior, but politicians on both sides aren't interested in doing them. Shrinking the industry and taxing transactions aren't solutions.
vostok 10y ago
Bankers are slightly more sophisticated estate agents and they have similar incentives. The basic business model is to do a lot of free work upfront in exchange for a shot at being massively overpaid for relatively simple work. I think the main problem is a classic principal/agent situation. The person who hires the bankers is often paying with someone else's money. This is really no different to other forms of enterprise sales. I think both are massively corrupt, but there seems to be a disproportionate amount of breath wasted on bankers as compared to other salesmen.
- mannykannot 10y ago
  > There seems to be a disproportionate amount of breath wasted on bankers as compared to other salesmen. Putting aside the question of how valid the analogy is, banking deserves the focus because of its importance to society, and the degree of harm it could cause.
  - vostok 10y ago
    How does banking cause more harm to society than, say, construction or databases or cars?
    - arcanus 10y ago
      Neither databases nor the construction industry are leveraged 10x+. Neither provides fundamental utility to other sections of the economy through lending activity, which can result in liquidity events at otherwise perfectly solvent firms. Neither can drive prices in other sectors through speculation in financial instruments or through financial reporting and reporting downgrades.
      - vostok 10y ago
        > Neither databases nor the construction industry are leveraged 10x+. Leverage is not the sole determinant of risk. Wildcatters are far riskier than someone who is 10x leveraged and holds 2 year notes. > Neither provides fundamental utility to other sections of the economy through lending activity, which can result in liquidity events at otherwise perfectly solvent firms. You picked the method of harm that is unique to finance. I could just easily claim that bankers will not build faulty levees or cause untold harm to the planet. > Neither can drive prices in other sectors through speculation in financial instruments or through financial reporting and reporting downgrades. It's not obvious to me that this is a method of harm. If oil is underpriced in the US and overpriced in Europe then buying one and selling the other will cause a shift in prices. Arguably this is a benefit because now everyone is paying/receiving fairer prices. Regardless, bankers are neither traders nor research analysts so I'm not sure how relevant this is.
saalweachter 10y ago
I feel like there's some sort of parallel with the Machine Apocalypse. "What if we build intelligent machines that execute their goals at the expense of humanity," we worry.
branchless 10y ago
Hard to disagree however it's the BoE blog and the BoE is responsible for this regulation. However their policy is to make the UK into the biggest finance cesspit imaginable in order to try and siphon off surplus value globally. There has been very little action against banks despite continuous fraud in the UK. Yet we have dawn raids for bank employees who go "rogue". The UK's only "industry" is banking. Their unique selling point is that you can come here and do whatever you like so long as you launder most of it through land to continue the UK fire sale to forestall total collapse.
yuhong 10y ago
Thinking about it, if you are going to print money, credit is probably one of the worst way to do it. Even something like basic income has its problems.
jernfrost 10y ago
I fundamentally disagree with the ideas of this article and think it is a wrong and harmful way to go about the problems in banking. It will create a dangerous precedence for other industry. The premise is based on a flawed homo-economomics understanding of human psychology. It is classical right-wing libertarian thinking, where the assumption is the only incentives driving people are greed and fear of punishment. These so called incentives are all stick and no carrot. People should be given a reason to do the right thing. Quite the contrary they are usually punished for doing the right thing. Whistle blowers have poor protection. Responsible employees get worse results than the reckless ones and thus get passed over on promotions or hounded by their managers. It would be much more effective to simple get rid of all the incentives designed to only measure financial performance and nothing else. Pay people to do a good job, rather than according to a narrowly defined metric of performance. The measurement based, new management style way of doing things has been poison everywhere in society not just banks. It causes police to arrest people just to fill their quota. Parking guards to write out tickets to meet target for number of tickets written by management. It makes hospitals push for unnecessary medical procedures. It is time to stop treating people like greedy robots, and actually accept that people are blessed with compassion and the ability to make complex decision. They will do that if you let them, rather than rewarding them for being reckless idiots.
- carsongross 10y ago
  Banking (and economics) selects for people driven by money more than other fields. It is not unreasonable to look to financial incentives and punishments to regulate people so inclined.
- Pyxl101 10y ago
  This is unrealistic. How do you measure whether someone "does a good job"? What if their job is to earn money while taking a certain amount of risk? This is ultimately what all banks do: all loans have a risk they won't be paid back, and the job of the bank is to earn money while managing that risk. I think if you tried to refine these ideas into something more specific and concrete, that would apply on a daily or yearly basis with respect to employee performance and compensation, you'd see that this idea needs to be a lot more fleshed out. You haven't considered how incentives play out at multiple levels in an organization or how to construct the right ones. There is no such thing as "just pay people for doing good work". The world doesn't have a ruler that can decree this and if it did there's still no way to enforce that it happens. You need to think about how to structure incentives for each person in the organization so that they shape behavior in the right direction. Personal liability is an incentive. "Pay people for doing good work" is not an incentive nor a policy that can be directly implemented. It is at best a goal that could be refined into policy and incentives after defining what exactly it really means. (What is "good work" and how do you know it when you see it?) The author of the article is advocating for creating a much stronger incentive to do the right thing by making people who work at banks personally liable for the outcomes of their decisions. The author specifically makes the point that people outside the system don't how to recognize "good work", but people within it do, and by making them personally liable, they will think twice before doing bad work.

63 points by bostik 10y ago

"Responsibility is a unique concept: it can only reside and inhere in a single individual. You may share it with others, but your portion is not diminished. You may delegate it, but it is still with you. You may disclaim it, but you cannot divest yourself of it. Even if you do not recognize it or admit its presence, you cannot escape it. If responsibility is rightfully yours, no evasion, or ignorance, or passing the blame can shift the burden to someone else. Unless you can point your finger at the person who is responsible when something goes wrong, then you have never had anyone really responsible." – Admiral Hyman G Rickover, United States Navy

Maarten88 10y ago

As long as risks are financial only, they will just get insurance against it and still get away with the current risk-taking behavior, passing the costs to the customer. Criminal punishments (jail time) might work. I think that taxing transactions in financial products would help a lot more, making the finance industry smaller, which I think would be very beneficial to society.

maxerickson 10y ago
If the insurance is correctly priced then the banks that don't pass the cost of risk on to customers should be able to compete nicely against the ones that try to.
- deleted 10y ago
  [deleted]
- winstonsmith 10y ago
  > If the insurance is correctly priced then the banks that don't pass the cost of risk on to customers should be able to compete nicely against the ones that try to. This theory breaks down if you distinguish between banker and bank as per the article. In the short term, the crooked banker with insurance can out-compete the honest uninsured banker by making high risk loans, not caring if the loans are paid back. In the short term the crooked banker can accumulate tens or hundreds of millions of dollars and happily retire when in the long term the loans fail and the bank goes bankrupt. The honest banker has to explain to his share holders etc. why crooked banker's bank is growing so much faster than his bank. His borrowers have to compete for houses against borrowers from crooked bank who can borrow more and therefor pay more for houses. His "under-performing" bank may become an acquisition target of crooked bank. The requisites for this dynamic are the absence of fear of criminal prosecution and perverse incentives via excessive CEO compensation.
  - maxerickson 10y ago
    Where's the insurance company in all this? They aren't going to sell a risky crooked banker a blanket policy that covers being crooked for nothing, they are either not going to sell a policy at all or are going to charge crazy premiums for it. Insurance isn't some magic thing that you just go get, it has a price set by well informed underwriters.
    - winstonsmith 10y ago
      Eg., AIG. The "magic" is that insurers can also be crooked, have CEOs with perverse incentives and effective immunity from prosecution, and be favored with bailouts.
VHRanger 10y ago
Making the finance industry smaller would not help society, because it would make lending more expensive. That would mean more expensive mortgages, more expensive loans, less VC funding, etc. Making big banks smaller also will not help socially because banks have returns to scale in diversification. So bigger banks are less likely to fail by themselves, and can lend for lower rates, which is socially good (recent research [1] [2] indicates this might not be true for the biggest banks -- they exhausted benefits of scale). Now one might ask if "too big to fail" effects might incentivize the bigger banks to act recklessly and counteract the above benefits? The answer is that there's the evidence does not back that up [3] at least for 2008 [4]. But that doesn't mean it is or is not the case going forward. Why did banks act so recklessly if they were not acting on too big to fail incentives, then? The answer, like in the OP, is management incentives. The managers could not give less of a fuck if the bank failed, because they were incentivized by shareholders, in the form of bonuses, etc. to generate large year-over-year profits. And in any market close to efficient, the only way to do that is to take on large risks. Not only did the managers not lose money if the bank failed, they didn't have any personal risk whatsoever. The lead up to 2008 was perfectly strategically rational coming from a bank manager's point of view. As the poster above me says, one way to fix that is to impose penalty from the judicial system. There's only so much financial regulation can do. But DoJ has been awful at that, even clearly criminal acts (remember HSBC?) doesn't send management to jail. [1] http://commons.colgate.edu/cgi/viewcontent.cgi?article=1053&context=econ_facschol http://commons.colgate.edu/cgi/viewcontent.cgi?article=1053&... [2] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2655448 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2655448 [3] http://fic.wharton.upenn.edu/fic/papers/11/11-47.pdf http://fic.wharton.upenn.edu/fic/papers/11/11-47.pdf [4] Remember the official fed policy was not to bailout banks coming into the crisis. They let the first behemoth fail, but quickly realized the disaster that awaited the global economy if they let the next one fail.
- collyw 10y ago
  I was under the impression that the finance sector has shrunk since the crisis. Lending rates seem to be pretty much the same.
  - 10y ago
zo1 10y ago
Either way, how can we expect such reform to happen when the politicians we elect to do our bidding aren't held to similar or larger standards? They barely have "career" risks in not getting elected if a policy fails. But that's only if it fails spectacularly-enough for the media to make a big fuss over it. Most of the time, they double-down and claim "lack of funding", or something. That's their get-out-of-jail-free card.
MR4D 10y ago
Your last sentence is an unbelievably ignorant comment. First, what are you going to tax? Credit card use? Home loans? Business loans? Exchanging money? Debit card use? Deposits & withdrawals? Secondly, making the financial industry smaller makes the economy smaller. There is a direct relationship. So if you want to shrink it, realize that your job, my job, and everyone here on HN will have their job at risk from a shrinking economy. The financial industry shrunk in 2008, and also in the great depression. You might want to understand the cause and effect in the business before you make comments like your last sentence. There are some simple solutions to the financial misbehavior, but politicians on both sides aren't interested in doing them. Shrinking the industry and taxing transactions aren't solutions.

vostok 10y ago

Bankers are slightly more sophisticated estate agents and they have similar incentives. The basic business model is to do a lot of free work upfront in exchange for a shot at being massively overpaid for relatively simple work. I think the main problem is a classic principal/agent situation. The person who hires the bankers is often paying with someone else's money. This is really no different to other forms of enterprise sales. I think both are massively corrupt, but there seems to be a disproportionate amount of breath wasted on bankers as compared to other salesmen.

mannykannot 10y ago
> There seems to be a disproportionate amount of breath wasted on bankers as compared to other salesmen. Putting aside the question of how valid the analogy is, banking deserves the focus because of its importance to society, and the degree of harm it could cause.
- vostok 10y ago
  How does banking cause more harm to society than, say, construction or databases or cars?
  - arcanus 10y ago
    Neither databases nor the construction industry are leveraged 10x+. Neither provides fundamental utility to other sections of the economy through lending activity, which can result in liquidity events at otherwise perfectly solvent firms. Neither can drive prices in other sectors through speculation in financial instruments or through financial reporting and reporting downgrades.
    - vostok 10y ago
      > Neither databases nor the construction industry are leveraged 10x+. Leverage is not the sole determinant of risk. Wildcatters are far riskier than someone who is 10x leveraged and holds 2 year notes. > Neither provides fundamental utility to other sections of the economy through lending activity, which can result in liquidity events at otherwise perfectly solvent firms. You picked the method of harm that is unique to finance. I could just easily claim that bankers will not build faulty levees or cause untold harm to the planet. > Neither can drive prices in other sectors through speculation in financial instruments or through financial reporting and reporting downgrades. It's not obvious to me that this is a method of harm. If oil is underpriced in the US and overpriced in Europe then buying one and selling the other will cause a shift in prices. Arguably this is a benefit because now everyone is paying/receiving fairer prices. Regardless, bankers are neither traders nor research analysts so I'm not sure how relevant this is.

saalweachter 10y ago

I feel like there's some sort of parallel with the Machine Apocalypse. "What if we build intelligent machines that execute their goals at the expense of humanity," we worry.

branchless 10y ago

Hard to disagree however it's the BoE blog and the BoE is responsible for this regulation. However their policy is to make the UK into the biggest finance cesspit imaginable in order to try and siphon off surplus value globally. There has been very little action against banks despite continuous fraud in the UK. Yet we have dawn raids for bank employees who go "rogue". The UK's only "industry" is banking. Their unique selling point is that you can come here and do whatever you like so long as you launder most of it through land to continue the UK fire sale to forestall total collapse.

yuhong 10y ago

Thinking about it, if you are going to print money, credit is probably one of the worst way to do it. Even something like basic income has its problems.

jernfrost 10y ago

I fundamentally disagree with the ideas of this article and think it is a wrong and harmful way to go about the problems in banking. It will create a dangerous precedence for other industry. The premise is based on a flawed homo-economomics understanding of human psychology. It is classical right-wing libertarian thinking, where the assumption is the only incentives driving people are greed and fear of punishment. These so called incentives are all stick and no carrot. People should be given a reason to do the right thing. Quite the contrary they are usually punished for doing the right thing. Whistle blowers have poor protection. Responsible employees get worse results than the reckless ones and thus get passed over on promotions or hounded by their managers. It would be much more effective to simple get rid of all the incentives designed to only measure financial performance and nothing else. Pay people to do a good job, rather than according to a narrowly defined metric of performance. The measurement based, new management style way of doing things has been poison everywhere in society not just banks. It causes police to arrest people just to fill their quota. Parking guards to write out tickets to meet target for number of tickets written by management. It makes hospitals push for unnecessary medical procedures. It is time to stop treating people like greedy robots, and actually accept that people are blessed with compassion and the ability to make complex decision. They will do that if you let them, rather than rewarding them for being reckless idiots.

carsongross 10y ago
Banking (and economics) selects for people driven by money more than other fields. It is not unreasonable to look to financial incentives and punishments to regulate people so inclined.
Pyxl101 10y ago
This is unrealistic. How do you measure whether someone "does a good job"? What if their job is to earn money while taking a certain amount of risk? This is ultimately what all banks do: all loans have a risk they won't be paid back, and the job of the bank is to earn money while managing that risk. I think if you tried to refine these ideas into something more specific and concrete, that would apply on a daily or yearly basis with respect to employee performance and compensation, you'd see that this idea needs to be a lot more fleshed out. You haven't considered how incentives play out at multiple levels in an organization or how to construct the right ones. There is no such thing as "just pay people for doing good work". The world doesn't have a ruler that can decree this and if it did there's still no way to enforce that it happens. You need to think about how to structure incentives for each person in the organization so that they shape behavior in the right direction. Personal liability is an incentive. "Pay people for doing good work" is not an incentive nor a policy that can be directly implemented. It is at best a goal that could be refined into policy and incentives after defining what exactly it really means. (What is "good work" and how do you know it when you see it?) The author of the article is advocating for creating a much stronger incentive to do the right thing by making people who work at banks personally liable for the outcomes of their decisions. The author specifically makes the point that people outside the system don't how to recognize "good work", but people within it do, and by making them personally liable, they will think twice before doing bad work.