Ten years after GFC, little has changed

For all the management waffle, ‘compensation’ practices are effectively the same — lots of upside, little downside.

Who would have thought women’s emancipation caused ­financial instability? It turns out that giving married women the right to hold property in their own right makes their banker husbands take greater risks, fuelling bank collapses, according to a brilliant new study.

Laws related to marriage haven’t figured prominently among the barrage of anniversary pieces for the global financial crisis, which exploded a decade ago this week when Lehman Brothers collapsed. And nor should they.

But the huge disparity between the gains and losses that arose from bankers’ decisions must figure prominently in any analysis of what became the biggest financial crisis in almost a century.

The incentives faced by individuals, not inanimate “banks”, resulted in far more risk-taking than was optimal for the rest of society. No other sector of the economy is capable of bringing real commerce to its knees.

Economists struggle to conduct experiments; it’s hard for them to hold everything else constant in the real word, except that one thing whose effect they would really like to examine.

This is where 1870s New England in the US comes in.

The Panic of 1873 was a financial crisis that ushered in a five-year depression, which saw the New York stockmarket fall 25 per cent and industrial product slump by more than a third.

Unemployment tripled but at least married women were more secure in their property. Beginning in the 1840s the states of New England began introducing laws that gave married women the right to hold assets in their right.

Banking was a different world back then. For a start, bank shareholders including their CEOs, who typically had significant holdings, faced “double liability”, ensuring they would think twice before risking depositors’ money on foolish projects.

Shareholders could lose up to twice what they paid for their shares, and US courts would and did go after shareholders’ assets.

“If a bank president was married before the enactment of a Married Women’s Protection Act, all of his family’s assets were at stake; if he married after, his wife’s separate assets were protected,” say the study’s authors, economists at Stanford and University of Chicago.

Their analysis, published this month, of hundreds of bankers and banks found those CEOs married after the change in marriage law leveraged up their banks more, made riskier loans, and lost far more shareholders funds and deposits in the Panic. Indeed, the wealthier their wives, the more likely they were to take risks.

I don’t think human nature has changed much since the 1870s.

If anything personal financial liability probably weighs more on bankers’ decisions today. In a sector where senior bankers tend to flit between banks, fealty to the institution doesn’t rate highly.

Double liability was a way of curbing risk-taking where management of other people’s money exposes shareholders, depositors and the economy to large risks.

For me a formative memory of late 2008 was how Merrill Lynch bankers earned enormous bonuses just as their bank went broke — a practice seemingly not in shareholders’ interest.

Top bankers at Bear Stearns and Lehman earned more in the few years before those banks collapsed than they lost in the collapse. Heads they win big time, tails means a bit more time in the mansion.

The worst that can happen to most bankers is losing their job, which if you’re already well off probably isn’t such a bad thing.

If reintroducing personal liability — forcing bankers to have some “skin in the game” — is a bridge too far, then how about limiting bankers’ upside.

Incentives that provide huge benefits without much downside should be curtailed unless banks organise themselves as partnerships, where liability is unlimited. Limited liability was never meant for big financial institutions.

Second, banks still don’t maintain enough equity. A library of analysis concludes banks with more equity relative to their assets underpin higher economic growth. For bankers, though, equity is kryptonite, reducing returns on equity and the implicit subsidy from the government that allows deposits to be raised at little cost.

Banks were a different beast back in the 1870s. They had to hold 15 per cent of their assets in the form of liquid government securities — “reserves”. And typically they were leveraged about two times, compared to around 25 times today in most rich countries.

For all the talk of reform, little has changed. Banks tends to be even bigger, more certain of government support, and for all the waffle “compensation” practices are effectively the same — lots of upside, little downside.

Maybe crashing the economy every few decades is worth it though if bankers’ risk-taking leads to more innovation and growth? Yet this same study found New England states with better capitalised (that is, more prudently run) banks were more likely to take up steam-power, the new technology of the day.

On the 10-year anniversary of the collapse of Lehman you’ll hear a lot about banks having taken on too much risk. Just remember only people take risks, and the structure of banking has changed very little.