Risk Aversion & Financial Death Penalties

A while back I read about Canada’s banking system.  It seemed to me that one of the main reasons why Canadian banks have fared relatively well in the crisis was the prevalence of a risk-averse culture among not only Canadian regulators, but also Canadian bankers.  The former, admittedly, appear to be aided by “principles-based regulation” – whose vagueness ironically (and beneficially) tends to induce a “chilling effect” (*) amongst those who’d take risks in Canada’s banks.  While I’m no fan of vague legal provisions, they may well have their place in financial regulation.  Still, the effectiveness of such laws would still depend on regulators; and regulators didn’t exactly acquit themselves well in the build-up to the financial crisis.  It’d be nice, therefore, if we could somehow induce American bankers to permanently adopt the same sort of risk-aversion that dominates their Canadian counterparts.

Now comes Delong with the following proposal (HT Steve):

I believe we need compensation reform: compensation schemes that make it a complete personal catastrophe for the CEO and all other employees if their bank fails. If managers and traders are, personally, wiped out–reduced in assets to their last two cars and their last four-bedroom house–if any financial institution they worked for goes bankrupt anytime in the next two years, then we have a chance of creating sufficient caution. Otherwise, I don’t see how we do it.

This reminds me of Kling’s proposal to jail the executives of failed banks.  Imprisonment seems a bit harsh for “mere” malfeasance; I like Delong’s better.  Let’s pass a law:  If financial firm requires a government bailout or resolution (e.g., via FDIC), all of its executives, traders, & loan officers shall be required to file for Chapter 7 bankruptcy, with the proceeds of the liquidations going to the creditors of their firm.

If bank failure is personally very costly for the executives & traders that run banks, those employees will have far stronger incentives to avoid any action that might result in such an outcome.  Voila:  a culture of risk-aversion among American bankers.  Recall also the “agency problem” that financial firms (and publicly-held companies in general) tend to pose:  If bank failure is either costless (or relatively less costly) for bank employees as compared with shareholders, the former will have greater incentives to take risks that shareholders, with skin in the game, might wish to avoid.  Threatening banks’ Powers That Be with bankruptcy in the event of failure might be a good solution to this agency problem.

We might also get some interesting knock-on effects, e.g.,

  1. Deterring aggressive risk-takers from entering banking;
  2. Deterring complexity in financial engineering (owing to the possibility of failure via unforeseen consequences);
  3. Deterrence, more generally, of the “best & the brightest” from pursuing careers in finance (since #2 creates less demand for their abilities).

Some might consider these downsides, but I’d consider them features, not bugs.  We don’t want risk-takers; we want conservative temperaments who’ll stick with what works.  And I’d much prefer to see our best & brightest designing microchips, or nuclear power plants, or green energy, or the like, rather than figuring out increasingly clever ways of shifting money around.

Another upside to this proposal is its simplicity:  no need for government to get involved in the nitty-gritty of designing banker compensation packages.  Let bankers compensate themselves however they want, so long as their firms remain solvent.  The government only gets involved in the event of failure.

(*) I.e., Since potential risk-takers can’t be sure of a regulation’s boundaries, they’re excessively cautious.  The term “chilling effect” is from First Amendment law; it refers to the ability of a vague law to “chill” speakers’ speech via uncertainty over precisely what sort of speech is illegal.


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