Bank Regulation: Are Paymasters The Answer?

Stung by a public outcry against large bank bonuses, both Treasury and Federal Reserve officials are “cracking down”. At seven companies that received federal bailouts – Citigroup, Bank of America, AIG, General Motors and Chrysler – bonus rules will negotiated with Treasury officials. Bonuses can only be in the form of stock that cannot be sold until all of the taxpayer money is returned.

Ben Bernanke, the Fed Chairman said “Compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability,” In other words, Bernanke is saying the way to cut risk taking at banks is to limit compensation.

I suggest this is crazy, foolish backassward thinking of the worst sort. Bank problems and the resulting global credit freeze were the result of bank trading activities: a predictable real estate downturn caused panic in the mortgage-backed securities market and trading stopped.

Yes, there were rules in place and we had bank examiners that were supposed to protect the public from such things happening. But the trading instruments are far too complex for bank examiners to understand and regulate effectively. Trading activities caused the problem. And Bernanke and other government officials want to limit trading activities by holding down compensation until the government has been repaid?

Well then, won’t the same practices start again? Won’t the banks start trading again, as Goldman has done, thereby putting the public once again at risk? Of course they will.

What we have to do, as I have argued earlier, is LIMIT TRADING ACTIVITIES IN BANKS! This can be done very simply. We did it in the ‘thirties when we forced banks to get rid of their trading arms. We should do it again. My suggestion is to tell banks they can only get FDIC coverage if their trading income is less than 10% of their total income.

The American taxpayer ultimately pays for the insurance services the FDIC provides. As depositors, we want our money to be safe. We understand that to be profitable, banks have to make a little more on its loans than it pays us for deposits. That is fine. But we have absolutely no interest on the other activities of the big banks – selling loans, repackaging them, selling them again, guaranteeing them, and trading.

The Bank for International Settlements has worked for more than a decade to develop a new set of standards for the capital adequacy of banks that allows for the riskiness of assets (Basel II). This in turn has spawned the risk management industry. Together, Basel II and its risk management industry is an unworkable joke. I have a couple of friends who are Federal bank regulators. They confess they have no idea what they are doing when it comes to large banks. To get some sense of what they are up against, I urge you to skim through the quarterly report of Citigroup at http://www.sec.gov/Archives/edgar/data/831001/000104746908011506/a2188770z10-q.htm. Scroll down to p. 34 and read to page 42. Enlightening?

If risk taking/trading is limited in banks, as I have proposed, there will be no need for government officials to negotiate compensation packages with companies. We will not need “special masters for compensation issues”. The risk takers will move on and leave banking to people only interested in serving their depositors.

I know, my proposal sounds too reasonable and simple to work. But it is what we should do. We won’t because the big bank lobbies won’t allow it to happen: Barney Frank and Chuck Schumer, where are you?

One final thought: have you noticed that everything being done to get us out of the recession will put us back in the situation that got us into this mess? The government is helping people with mortgages and credit card programs; the Feds are trying to get asset-backed securities market going again, and we are throwing money at the financial sector so it can do the same things over again.