[Vision2020] The Simplicity Solution

[Art Deco]

  [image: The New York Times] <http://www.nytimes.com/>

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May 28, 2012
The Simplicity Solution By JOE NOCERA

Time to fess up: With the two-year anniversary of the passage of the
Dodd-Frank financial reform
law<http://dealbook.nytimes.com/2010/06/28/the-dodd-frank-bill-up-close/>approaching,
I’m still not sure what to think about the darn thing.

Will the law prevent another bank bailout if we have a repeat of September
2008? Will it bring transparency to the trading of
derivatives<http://topics.nytimes.com/top/reference/timestopics/subjects/d/derivatives/index.html?inline=nyt-classifier>?
Will the Volcker
Rule<http://topics.nytimes.com/top/reference/timestopics/subjects/v/volcker_rule/index.html?inline=nyt-classifier>truly
eliminate the ability of banks to make risky trades for their own
account? Are all the new regulations burying small and medium-size banks in
excessive costs? Or are they ensuring their safety and soundness? No one
can say for sure.

The crucial difference between the Glass-Steagall
Act<http://law.jrank.org/pages/7165/Glass-Steagall-Act.html>,
the landmark banking reform law that was passed during the Great
Depression<http://topics.nytimes.com/top/reference/timestopics/subjects/g/great_depression_1930s/index.html?inline=nyt-classifier>,
and Dodd-Frank, is that the former had an appealing simplicity that
Dodd-Frank lacks. Glass-Steagall did one basic thing. It forced banks to
get rid of their investment banking arms. Dodd-Frank, by contrast, accepts
the complexity of modern banking — and then adds to that complexity with
its thousands of pages of regulations. That complexity is something to
worry about.

That is why I wrote a recent
column<http://www.nytimes.com/2012/01/17/opinion/bankings-got-a-new-critic.html>about
a persuasive paper by Karen Petrou, a banking expert, in which she
argued that Dodd-Frank was creating a new kind of risk that she labeled
“complexity risk.” And it is why, last week, I found myself drawn to an
article in the June issue of The Harvard Business Review that argued for a
handful of simpler ways to restrain banking behavior.

The article <http://hbr.org/2012/06/four-ways-to-fix-banks/ar/1>, entitled
“Four Ways to Fix Banks,” was written by Sallie
Krawcheck<http://topics.wsj.com/person/K/sallie-krawcheck/5353>.
At 47, Krawcheck has been through the banking wars. She had several
high-level jobs at Citigroup, including chief financial officer; most
recently, she successfully ran Merrill Lynch’s huge brokerage operation for
Bank of America. (She left last September.)

In a nifty bit of timing, her article comes out just as the country is
reacting to the news of JPMorgan Chase’s big credit derivative
losses<http://dealbook.nytimes.com/2012/05/10/jpmorgan-discloses-significant-losses-in-trading-group/>.
To Krawcheck, the questions posed by the JPMorgan fiasco speak directly to
the problems posed by complexity. “The JPMorgan loss is manageable,” she
told me the other day. “But it allows us to stand back and ask: ‘What does
this say about the banking system?’ ”

To her, it says that even at an institution as well run as JPMorgan, the
complexity of banking can be overwhelming. “It appears the trades
themselves were so complex that the risks were not well understood,” she
said. “The bank management didn’t understand them. The regulators weren’t
aware of them. And the bank’s risk management system didn’t pick them up.”

Indeed, in her view, all the talk about whether the Volcker Rule would have
prevented the trades is beside the point. To her, the issue is not whether
a bank is taking excessive risk for its own account. It is whether the
bank’s overall risk profile makes sense — no matter what the purpose. “How
much risk do we want banks to take?” she asks. “That is the debate we need
to have.”

In her Harvard Business Review article, she lays out a handful of
market-oriented ideas that would almost surely pare back the complexity
risk posed by banks. My favorite is her first one: top bank executives and
senior management should be paid in bonds as well as stocks — and in the
same percentage as the bank’s risk profile. Thus, as she envisions it, a
bank that had a dollar of debt for every dollar of equity would pay its
chief executive half in debt and half in stock. But if the bank was
accumulating, say, $30 of debt for every $1 of equity, the executive’s pay
would also be skewed 30 to 1 in favor of debt. One would be hard pressed to
imagine a more surefire way to focus a banker’s mind on making sure the
bank could pay back that debt.

Her other ideas are almost as good. She thinks dividends should be paid as
a percentage of earnings — so that if earnings decrease, the bank can
retain more of its capital. She says that bank managers should be judged
less on the earnings they generate and more on the quality of those
earnings — partly because earnings are often a function of interest rates,
which bank executives have no control over. And she argues that bank boards
should pay much more attention to the businesses that seem to be booming.
In banking, those are often the businesses that can cause the nastiest
surprises.

It is good that people like Karen Petrou and Sallie Krawcheck are raising
alarms about complexity — and putting forth some sensible, and simpler,
solutions for making banking safer. Unfortunately, even after the JPMorgan
fiasco, it is unlikely that anyone is going to act on them — at least not
right now. The Democrats are wedded to Dodd-Frank, while the Republicans
care only about putting up roadblocks to Dodd-Frank’s implementation.

Sadly, the only thing that will change that is another crisis. Until then,
we’re stuck with complexity.




-- 
Art Deco (Wayne A. Fox)
art.deco.studios at gmail.com
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