Originally Published July 28, 2016
Reviewed by Martin Fridson, CFA
During the period of excesses that preceded the 2008 global financial crisis, some Morgan Stanley (NYSE:MS) bankers responsible for structuring a collateralized debt obligation (CDO) emailed one another about the name to select for the deal. They jokingly considered "Nuclear Holocaust 2007-1," "Subprime Meltdown 2007," and "Mike Tyson's Punch-Out." In a ruling in a lawsuit that arose from the large loss suffered by one purchaser of the CDO, the court opined that the emails suggested a motive on the part of Morgan Stanley "to quickly dispose of troubled collateral (i.e., predominantly residential mortgage-backed securities) which it owned at the time." The cynical tone of the communications also pointed to a cultural problem on Wall Street.
Professors Claire A. Hill and Richard W. Painter of the University of Minnesota Law School do not regard ethical failings in the financial industry as the actions of a few bad apples, but rather, as inevitable consequences of an unhealthy culture. They cite US District Judge Alvin Hellerstein, who gave a Credit Suisse (NYSE:CS) trader a lighter sentence for fraudulently marking up bond prices than the advisory sentencing guidelines recommended on the grounds that his infraction was "a small piece of an overall climate" at his and many other banks.
In the view of the authors of Better Bankers, Better Banks, the cure does not lie in increased regulation and stricter enforcement. Almost all of the biggest financial companies have settled fraud cases with the US SEC by promising never again to violate an antifraud statute, only to become repeat offenders and pay substantial fines without admitting or denying guilt. The authors cite a New York Times analysis of enforcement actions over a 15-year period that found at least 51 instances in which a total of 19 firms broke laws they had vowed not to break again.
An additional problem with relying on prosecution is that large financial institutions have vast resources for finding ways to comply only minimally with regulations and to impede attempts to force them to comply more fully.
Instead of continuing down that unproductive path, say Hill and Painter, the government should focus on changing bankers' incentives. Specifically, the authors seek to restore the environment that existed before the major investment banks transformed themselves from partnerships into publicly traded corporations. (Prior to 1970, member firms of the New York Stock Exchange were not allowed to have outside owners.) Under the old form of organization, the authors argue, personal liability for their firms' losses strongly discouraged partners from engaging in ultra-high-risk transactions and skirting the law.
"Covenant banking" is the name Hill and Painter give to their proposed mechanism for simulating the incentives of the partnership era. In one of several possible variants they offer, the most highly paid employees - say, those earning more than $3 million a year - would make all of their assets less $2 million available to pay their bank's debts if it failed. Another alternative would revive the concept of assessable stock. This tool, widely used in commercial banking prior to the 1930s, requires the holder to agree to pay amounts over and above the initial cost of the shares if necessary to save the bank. Whichever particular version of covenant banking became the norm, bankers would be motivated to refrain from actions that put their firms in jeopardy and would also have an incentive to monitor and control their fellow employees' actions.
Continuing in a vein that readers may find surprising in a book written by law school professors, Hill and Painter do not advocate a legal solution of making covenant banking compulsory. They prefer voluntary compliance, but they recommend that banks be required to disclose to shareholders the particulars of the personal liability requirements of their most highly compensated employees. Banks that have no such covenants in place would be required to explain why. Presumably, investors would be less inclined to deal with the firms that do not adopt covenant banking, resulting in a powerful financial incentive to do so. The government could reinforce that incentive by such measures as giving adopters privileged status in US T-bond auctions.
The problems addressed in this book affect every participant in the financial system. Investors and securities issuers suffer when banks with which they deal prove untrustworthy. Analysts, risk managers, and compliance officers working in what Judge Hellerstein described as a "toxic culture" may encounter pressure to compromise their ethical standards. It is, therefore, to be hoped that the concept of covenant banking will receive serious attention both within the financial industry and in Washington, D.C.
Hill and Painter's recommended innovation would not eliminate all wrongdoing. After all, Wall Street had miscreants even in the era of partnerships and assessable stock. No other proposed reform, however, seems as likely to discourage the most aggressive bankers and traders from sailing close to the wind.
Happily, reading Better Bankers, Better Banks is by no means an arduous, if necessary, chore. Nonlawyers can readily grasp its nontechnical discussions of legislation and case law. The authors sustain interest with colorful anecdotes. For example, they quote Goldman Sachs (NYSE:GS) CEO Lloyd Blankfein, who joked that at his previous employer, J. Aron and Company, a precious metals trading firm that was acquired by Goldman, the words "client" and "customer" were never used. "We had counterparties," Blankfein said, "and that's because we did not know how to spell the word 'adversary.'" In depicting the advantages of the old partnership structure of Wall Street firms, Painter recalls inspirational conversations with his late grandfather, Sidney Homer, a revered pioneer of bond research at Salomon Brothers.
Combining readability with thorough documentation, including 36 pages of endnotes, this book contributes in an original and valuable manner toward combating ethical abuses in the financial markets.
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