Response and Reaction to Prof. Todd Henderson's Proposal for Bank Regulators to Have Incentive Compensation Sparks Discussion of Financial Institution Regulation in General

Trying to Find Clarity and Common Ground


[Editor's note:  This post deviates from the usually sarcastic and snarky comments of The Dismal Political Economist.  This is because the discussions have caused him to focus on the more general aspect of regulation of financial institutions.   We apologize for serious tone and somewhat boring content of this Post and will try to avoid such posts in the future.]

This Forum commented negatively on a proposal by University of Chicago Professor Todd Henderson (and Professsor Frederick Tung) who recommended providing bonuses and phantom stock to bank regulators to incent them to manage and control the risk that their charges take.  A follow-up post was made, and Prof. Henderson has now commented on that post.  Here is his full response.

Todd HendersonJune 14, 2012 8:48 PM

Thank you for reading and confronting the paper head on. I appreciate that.

I think you misunderstand banking regulation. You are right that what we describe as the role of banking regulators is not the typical sort of regulation, which you rightly describe. Bank regulators have a very different function. They have enormous power to shut down banks or bank activities based on an analysis of risk. The bank examiner manuals for the regulators and the post mortem reports of banks done by inspectors general make this abundantly clear. In a working paper with James Spindler (Texas) that is not yet published, I am developing a formal model of this sort of regulatory model, pointing out the inherent problem with it. But that is for another day.

With his position with respect to the issue that banking regulation by bank examiners is ‘different’ in that among other things bank examiners have the power to shut down banks or stop bank activities, he is indeed correct.  But the focus on bank regulation, given the recent financial crisis brought on in part by the problems of not just banks but other types of financial institutions should move to a broader topic and examine regulation of large multi-national banks (who are the real threat) and non-bank financial institutions.

A discussion of regulation of financial institutions is needed for regulation of the large international financial institutions like Citibank, J. P. Morgan Chase, B of A, Goldman etc, and there the regulation is different from the micro bank examiner level.  No regulator, bank examiner or even regulatory agency is going to shut down Citibank or micro manage their trading desks.  So at that level regardless of what the regulators can do with smaller banks, the way they can regulate the large bank and non-bank financial institutions is different, and much more typical of other regulatory bodies.

In terms of broad principles, regulation of the financial institutions has three main inter-dependent goals.  One is to preserve the safety and liquidity of deposits.  The second is to regulate the banks and other financial institutions in a manner such that their function of providing credit services and transaction services to the economy is not impaired, because if it is the economy cannot fully function. 

The third goal is to prevent the failure of the financial institution, particularly when that failure would have externalities and disrupt the economy in general.  When a financial institution fails the equity investors in the bank and those who hold bonds of the bank should suffer losses, but those who are not connected with the institution should not be impacted.  This is the basis of the concept of ‘too big to fail’ and why the banking system had to be bailed out in 2008 under President George W. Bush. The failure of the large banks and financial institutions would have had significant and severe impact on the rest of the economy.

For example the failure of M. F. Global, a regulated financial institution that was not too big to fail was only partly a regulatory failure in that depositor’s funds have been lost.  Other than that the failure of the institution did not violate the three principles stated above.  The regulatory related problem with M. F. Global was not inappropriate risk taking, it was the failure to properly segregate and safeguard deposits.  Mr. Henderson’s structure would not have prevented this regulatory failure unless regulators fully understood and had simply forbid the trading positions that M. F. Global had taken. (Heck, there is a great possibility that Jon Corzine did not even understand what he was doing).  

The problem is that large banks and financial institutions have evolved into institutions whereby they use the leverage and the capital of their traditional banking activities to support massive trading with substantial risk.  They no longer look to the portfolio of assets as one largely to be held, but as a portfolio to be traded.  Absent a housing bubble, trading risk and trading failure is what destroys these institutions (again see M. F. Global, the most recent example).

There are two obvious and effective solutions.  One has already been implemented successfully.  Following the Great Depression commercial banks and other 'real' banks were required to be just that.  Any other activity had to be totally and legally separate.  This separation broke down in the ‘de-regulation’ era.

De-regulation fixed a problem that was not present, it was an answer for which there was not question. Restoring it on a very strict basis and applying traditional bank regulation to those ‘real’ commercial banks would solve much of the problem, as it did for decades after the banking debacle of the 1930’s.

As for the non-commercial banking financial institutions that wish to take risk and have risky trading positions, the role of regulators in that instance is largely to make the positions and the strategy transparent and to make certain that deposits, if any, are protected.  If they monitor and regulate the handling of customer deposits and insure that adequate, proper and correct information is supplied to the shareholders and bond holders, the market should do a far better job of ‘regulating’ than regulators trying to control risk on a micro level could do.  Poorly managed and imprudent companies will be denied capital, not always but certainly a great deal of the time.

If stock and bond investors, with full understanding of the activities and risks associated with a non-banking company engaged in trading and hedging and other complex financial strategies wish to invest, fine.  If they lose their investment but the economy as a whole is not affected, so be it. 

The second solution, less efficient, is capital adequacy.  The degree of capital needed is directly related to the risk of the institution.  This regulatory action would be successful except for the political power of financial institution who resist it because it lowers return on equity and denies banks the leverage needed to make a trading desk profitable. In this scenario you don’t micro-manage the risk activities of the bank, you need to insure the it has sufficient capital and deposit protection so that its losses do not violate the three goals stated above.

So in the end the issue in not that a new system of regulation is needed and it is not that the science of regulation does not know what to do.  It is that political considerations and the power of those subject to regulation have defeated proper regulation.  (The Freddie Mac and Fannie Mae contribution to the housing bubble and their subsequent disaster could have probably  been avoided if at any time in the past 40 years the Federal government had simply said, "These are private companies, the Federal government assumes no responsibility for their obligations.")

Yep, that would have done it.