Crimes of Banking: Optimal Deterrence

By James Kwak

Felix Salmon has been helping popularize Paul Collier’s idea of bankslaughter. (No, it’s not what you wish it were.) The idea is that there would be a crime called bankslaughter, or “managing a bank irresponsibly.” If a bank blows up, there could be a criminal investigation to determine if the bank managers behaved recklessly (more on that term later); if so, they would be convicted. The analogy is to manslaughter, which is actually a family of crimes; Collier probably means criminally negligent homicide, or causing death through negligent or reckless (more on those terms later) behavior.

Not surprisingly, the conservatives are not happy about this, even though it seems to conform to the conservative principle that people should bear responsibility for the consequences of their actions. (Or maybe that only applies if you are a pregnant teenager.) Salmon cites John Carney, who calls bankslaughter “the worst idea of the week.”

Here are some of his objections:

Collier doesn’t seem to have given much thought to the costs of over-deterrence. Bank executives faced with the prospect of a criminal investigation and possible conviction would likely be overly cautious. We’d lose a lot of socially beneficially risk taking by criminalizing bank failure.

There’s also a serious fairness issue. Only those executives whose risky bets blow up get investigated, prosecuted and punished. Those whose bets pay off are untouched. This means that being unlucky in the markets becomes a criminal matter. Criminality becomes a kind of lottery. . . .

Because bankslaughter is backward looking but conducting business is forward looking, it would almost certainly result in wrongful convictions. Lots of activity that looks reckless after the fact can seem perfectly sensible ahead of time. Unless the crime required bankers to know they were being reckless—in which case it would deter almost no-one and result in approximately zero convictions — it would wind up punishing bankers for just being wrong.

Regular readers can guess what I think of the idea of “over-deterrence.” We need some more over-deterrence. People can talk all they want about “socially beneficial risk taking,” but the evidence that this happened during the last thirty years is pretty contestable. For a system to have the optimal amount of risk taking, it is necessary (but not necessarily sufficient) that the people who stand to benefit from the venture internalize the risk of failure in some way; as everyone on the Internet has written multiple times, that condition did not hold for the financial sector in all sorts of ways.

But the more interesting argument is whether there is a problem with retroactively holding people liable for harm that they cause unintentionally. Carney writes as if this is just a crazy idea: first, only the people who actually cause harm are prosecuted, as opposed to others who behave equally egregiously but are lucky enough not to cause harm; second, it allows juries to evaluate behavior in the past with the benefit of hindsight.

What he doesn’t say is that this is exactly how a huge chunk of our legal system works today. It’s called torts, and even though I’ve only had one year of law school, and that was at Yale, where the joke is that you don’t actually learn any law, I know something about it. The general principle is that in most spheres of life, if you act negligently – defined to mean that you do not exercise the same degree of care a reasonable person would under the circumstances – and your action causes injury to someone else (to whom you owe a duty of care), you are liable for that injury. In some areas, the threshold is lower; for example, in product liability, the rule of strict liability applies, which means that you don’t even need to be negligent; if your product hurts someone, you’re liable. In other areas, the threshold is higher, and the requirement is not just negligence, but gross negligence, or willful wanton recklessness, or something like that. But that’s the basic principle; you don’t need intent, and the legal system certainly does assign liability after the fact.

So, for example, if you take a turn too fast on a wet road and you hit someone, you’re liable; but the twenty drivers ahead of you who all took the same turn too fast aren’t liable for anything. And juries decide whether you were being negligent with the benefit of hindsight; they know that the baby stroller was in the intersection, which you had no reason to know when you took the turn (and was highly unlikely, since it was late at night and raining). That’s just the way the law works.

Ironically enough, the modern tort system is a product of the second industrial revolution of the late nineteenth century, and was designed to cater to the needs of large businesses. By creating an objective, supposedly predictable and stable standard of negligence, it made it easier for businesses to manage the risks of their operations. And while there are certainly things they criticize, tort law is one of the main areas where the law-and-economics crowd has won out, and real judges actually talk about things like “cheapest cost avoiders.” For many scholars and jurists, the standard of reasonable care is defined as the degree of care such that the marginal benefit of accident avoidance equals the marginal cost of care; you can see how, in a tautological way, this creates a Panglossian “best of all possible worlds,” since it yields the perfect degree of deterrence. And the reason most economist types (and free marketers) like this way of thinking about tort law is that the whole point of the law is to create the right incentives without the need for all sorts of detailed regulation.

So Carney’s idea that this type of liability would produce over-deterrence is a bit curious. To get optimal deterrence in the bank-management context, you want managers to take precautions (e.g., maintain capital reserves) up to the point where the marginal reduction in the risk of a collapse is balanced by the marginal cost of those precautions. Today, we have no such thing, since we have no meaningful risk of collapse for bank managers, since their downside (relative to their upside) is limited by (a) leverage, (b) the implicit government guarantee, (c) the bonuses they got in the good years, and (d) the “resume put.” Because there is no liability for blowing up a bank, our legal system provides no deterrence whatsoever, which is one reason why we need regulation. (In a perfect law-and-economics world, you wouldn’t need regulators, since the threat of liability would create optimal behavior all by itself.)

Now, I don’t think that Collier has all the details right. First, I think that criminal prosecution for mere negligence is overkill; civil liability would be plenty, since that way you could go after all of the negligent manager’s assets, including his bonuses from the good years. We could save criminal prosecutions for people who commit actual fraud. Second, Collier uses “recklessness” and “reasonableness” as perfect opposites, which, from a legal standpoint, they’re not; you can fail to behave as a reasonable person would (that’s negligence) without your conduct rising to the level of recklessness.

The thing standing in the way of a civil version of bankslaughter is the business judgment rule, which basically says that if you are a manager who makes an informed decision in a situation where you do not have a conflict of interest, you are not liable, period, no matter how risky or stupid that decision is. And as far as I know, no court has ever held that having a bonus tied to your company’s stock price, with no commensurate downside risk, counts as a conflict of interest (even though it is). The point of the business judgment rule was to enable managers to take risks without fear of liability (or to enable rich people to sit on boards of directors and become even richer doing very little work without fear of liability). But in an environment where it’s very clear that managers were taking too many risks, because there was no way they would suffer the potential consequences of those risks, one very logical and sensible solution is to turn the dial partially back the other way and increase liability, which I see as Collier’s basic point. Since the business judgment rule is basically common law, it could be pared back by statute, and it could be pared back selectively – for example, for businesses whose blowups can have large societal costs.

One weakness of the Obama Administrations financial regulation proposal is that it doesn’t increase real costs for the key actors – bank managers and directors. Instead, it relies on better regulation enforced by better regulators. A civil version of bankslaughter could help fix this problem.

Comments

[Clive Corcoran:]

If I understand your point correctly precedents need to be set for motivating more class action lawsuits through the civil courts which would find managers/directors liable to repay bonuses and other compensation from poor decisions in the running of a bank.

In comparing that to (say) class action suits against tobacco companies one would need to establish that there exists a body of independent evidence that shows categorically that risk management tools and methods are inherently dangerous.

Whilst intellectually that is a very appealing notion (at least to me) one could also understand the reluctance of "experts" from academia or the financial establishment who would provide such testimony.

Jul 09 03:20 PM

[Mark Bern:]

Why stop there? Would the banks have gotten themselves in this terrible conditon if regulatory oversight had done its job. Where does that buck stop? Who should be held accountable for not funding or allowing bank examiners do their jobs?

I realize that we probably can't start asking elected officials to keep their hands out of the proverbial candy jar and tinker with regulating bodies. Nor can we place all the responsibility of bank failures upon appointed officialls. But, in the final analysis, there was enough negligence on the part of Congress and former Administrations to condone such actions.

If the federal oversight bodies had been doing their jobs all along, we could have avoided the crisis; leverage would not have been allowed to run up to unsustainble levels and bank reserves would have been maintained at levels adequate enough so as not to have required a federal bailout. Yes, perhaps a rogue banker or two would have snuck by the examiners' through slight of hand or outright fraud, but then there would tangble evidence to be used to hang the wrongdoers: Intent.

I'm not saying that your argument is wrong. I'm just pointing out that we have regulations on the books that worked up until politicians started meddling and constricting the abilities of those in change of regulating. And I think that this is an issue that needs to be address before we send everything to the courts. My fear is that, like other industries with high inherent risk such as medicine, if we always turn to the courts for answers the costs to consumers will skyrocket and the only parties that will enrich themselves as a result will be insurance companies and lawyers.

If we raise the risk levels for the executives, the banks will have to furnish some new form of insurance to protect them from financial loss or no one will accept the responsibility.

I think that we need to start at the beginning and understand when and how the regulatory oversight started to fail and fix that first.

Jul 09 04:26 PM

[xxxx:]

I wish people would stop talking about the bankers as if they were actually human beings, because they are not and should not be treated as such. I will quote from the FT today regarding the consumer protection watchdog.

"banks are lobbying furiously to stop the consumer Financial Protection Agency's creation o to remove it most sweeping powers, which include forcing brokers and banks to offer simpler mortgages and credit cards alongside other products."

Considering all they have gotten, all they have gotten away with, endangering the dollar, our national budget, and causing more harm than Osama bin Laden one would think that what is being asked for in return is reasonable. But nothing is reasonable to these animals. It doesn't matter what or how much you give them they always want even more.

They should be treated like the sick animals they are and just put down for the sake of society.

Jul 09 06:10 PM

[donzelion:]

Conservatives viewed the establishment of the SEC as part of FDR's communist conspiracy to destroy capitalism.

Two points though: First, "By creating an objective, supposedly predictable and stable standard of negligence, it made it easier for businesses to manage the risks of their operations." The problem arises when the "reasonable man" standard is being applied to systemic conduct beyond the understanding of any reasonable person. Then an "objective" standard becomes utterly meaningless (and that's the main reason to move from tort or contract and into administrative law).

Second: perhaps torts is taught differently at Yale, but in general, the business judgment rule shelters against liability for breach of fiduciary duties to shareholders, not against tort liability (e.g., shareholders claim that the company wasted their assets by dumb choices, they get no relief if the company was exercising its business judgment). If a company acts negligently, it will still be liable (and the company could conceivably recover bonuses through clawbacks for specific persons who act negligently).

Jul 09 08:14 PM

[Moon Kil Woong:]

Hmmm the failure of our current banking system is not that bankers were doing other things than banking, like gambling in brokerage businesses and writing insurance policies called CDOs and CDS etc. Thus Glass Stegal would go a long way in solving the problem without criminalization.

However, if used bankslaughter was used to coerce them into accepting Glass Stegal again, I would be all up for that. Unfortunately, if implemented bankers would just start insuranceslaughtering and brokerslaughtering everyone. Ooops, I guess they already started doing that. Sorry Bear and AIG. I didn't see you even though you were big and standing around for decades.

Jul 09 08:30 PM

[Arthur Hau:]

Why not a "lawslaughter" instead?

Who proposed and voted for the deregulation of banks, insurance companies, and other financial institutions?

Who proposed and voted for the creation of Fannie and Freddie?

Who failed to regulate the creation of new investment products such as mortgage backed securities?

Who failed to investigate into the Madoff case back in 2001 when someone filed a "reasonable" complaint stating that Madoff's investment results were mathematically and statistically impossible?

Who have kept the interest rate at record low for so many years and have eventually created a mega bubble in the real estate and the stock markets?

If investment bankers, insurers, and commercial bankers were to go to jail for their irresponsible acts, politicians and regulators should have faced death penalty first.

Jul 10 01:41 AM

[TinyTim:]

James-
good article.

"civil liability would be plenty, since that way you could go after all of the negligent manager’s assets, including his bonuses from the good years."

And don't forget the bad year bonuses also. Levity aside, employees/managers are protected from torts. That's the basis for asset protection via incorporation, LLC's, etc. You'd have to go after the entire bank instead of individuals. This is a serious loophole.

As you mention, the most serious loophole is the business judgment rule. Rather than peel this back, I would rather get rid of the TBTF businesses so the rest could run rampant wrt risk.

The business judgment rule is a slippery slope. I was just reading an argument that this is the reason for herd mentality among financial advisers and brokers, and more importantly and ironically, lack of risk taking. The key phrase being informed decision. If you're doing what everyone else is doing, as opposed to being innovative, your clients can't come after you when they lose 50%.

Jul 10 06:28 PM