Bankers need to be personally liable to avoid future financial crises — new research

Most financial crises have plenty in common. They tend to start in the banking sector and involve excessive borrowing, together with an asset bubble, usually related to property.

The global crisis of 2008 was no different, with the asset bubble focused on US real estate. But my research suggests this crisis had another underlying cause – that some people in the banking sector were playing or “gaming” the system for their own financial gain.

The game being played had several important features. First was the deliberate complexity of the financial products at its core – in particular the products based on pooling residential mortgage loans (called “mortgage-backed securities”) that were sold by banks to other banks and institutional investors.

These products were issued by the very banks that had offered the mortgages to customers who did not earn enough to pay the mortgage interest, and relied on ever-increasing house prices to stay afloat.

Then there are the behavioural biases that pervade decision-making at all levels of the banking industry. My research found that banking can often attract a certain kind of person: those who are prone to overconfidence, excessive risk-taking and, in some cases, psychopathic behaviour.

Such people tend to like complexity for its own sake. But they often do not fully understand the implications of that complexity for the stability of the financial system as a whole. Often they do not care – they are primarily interested in gaming the system to maximise their bonuses.

The next element is risk. There are parts of the banking sector that will always be prone to risk, but my research suggests that many bankers have come to feel immune to its potential impact. Instead, they are comforted and emboldened by the view that, however recklessly banks behave, governments – and hence taxpayers – will always be there to bail them out.

Meanwhile, financial regulators attempt to set out effective rules and codes to mitigate risk. But this usually results only in a continual game of cat and mouse with an industry constantly seeking to circumvent any regulations they consider too onerous.

Game over?

Given all of this, there are no effective measures that any government would be prepared to introduce to deal with this situation. There have been no serious attempts to recognise or address the issue of product complexity, and when it comes to dealing with behaviour and personality types, everyone – including employees, managers, directors and even regulators – is susceptible.

Previous attempts to combat systemic risk in finance were based on the underlying assumption that the financial system is rational and that bankers want to behave rationally if they are given the right incentives. But these assumptions, my research indicates, are questionable.

Gaming in the banking sector seems virtually impossible to eliminate. The only effective measure to end it would be to make bankers personally liable for losses, to remove the sense that their actions – their games – have no personal financial or legal consequences.

It is this, rather than removing the cap on bankers’ bonuses, that has the best chance of preventing the financial system blowing up again.

Beware the game playing wolves.
Shutterstock/Krzysztof Stefaniak

However, no government has ever passed such a law. And no single government could do so on its own, since this would immediately cause their entire national banking sector to move wholesale to another jurisdiction.

The law would have to be introduced simultaneously in all countries – and the probability of this happening is negligible. In short, the only effective measure to limit gaming will not, and cannot, be introduced.

This may seem like a bleak conclusion, and in many ways it is – particularly for taxpayers. But there is a more positive alternative, which entails the industry returning to the simple products that the banks, their regulators and their customers understand. In most cases the complexity is unnecessary.

Read more:
Bankers bonus cap: why scrapping it could hurt the UK economy

For we should not forget that the main functions of banks are pretty straightforward: to raise funds from depositors and wholesale markets in order to lend to households and businesses. Banks have been providing these services successfully for centuries. But today bankers are not interested in simple products – because they are more difficult to game.

Until that changes, the really important lesson of the global financial crisis is that it is bound to be repeated. The “great game” will never end.

by : David Blake, Professor of Finance & Director of Pensions Institute, City, University of London

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