“Better Bankers, Better Banks” is an intriguing account of all the scandals and problems in banking that we appear to have become accustomed to. Professors Hill and Painter offer a fascinating new proposal on how to address these problems, which is as topical in the US as it is in Europe. In short, what their proposal amounts to is to rebalance the upside and the downside participation of bank managers in the profits and losses of their bank. Whereas before the crisis, regulatory efforts have long sought to align bankers’ incentives with the upside (by offering variable pay, bonuses, etc), there was very little attention on how to account for the downside risk. The idea of “covenant banking”, i.e. a form of self-commitment in the firm’s losses, is an important contribution to the current debate on how to improve banking culture post-crisis.
Inevitably, as soon as a proposal is on the table, market participants will want to know how it works in practice. In the following, I offer a few thoughts and questions that may broaden the debate towards its effects and implications.
First, how strongly would we encourage banks (or bankers) to make use of covenant banking. I am a little sceptical on whether they might adopt covenants deliberately. Some form of a government nudge would certainly be required. Different nuances in the regulatory toolkit are available. It seems to me that offering a best practice recommendation or a legislative menu with different options could be a sensible step to take. Findings from behavioural science support the effectiveness of such soft law standards.
Secondly, how will the market respond? Will clients and customers appreciate the stronger commitment that an individual banker’s “covenant” involves? Will they be able to digest the additional information appropriately? I would argue that a certain standardization of the covenant might help. If a small number of different covenants were “on offer”, endorsed by legislature or best practice code, the public would be much better placed to appreciate them. By contrast, if you leave firms to develop a million different tailor-made types – with exceptions, limitations and exclusions – creditors will not be able to price in their value correctly. This even more when you add an international perspective – jurisdictions will differ in their prescriptions and make it difficult to appreciate them in cross-border cases.
My final point is a little provocative: do we really get “better” bankers by making them liable for the firm’s debts? My pessimistic view of human nature is that bankers will still have strong incentives to work around their covenants – and possibly even use them as a commitment signal but do the opposite. Monitoring by creditors is therefore essential. This is another reason for why the rules should be clear, transparent, and somewhat standardized.
Hill and Painter have started a captivating journey, and I congratulate them on designing a stimulating new conceptual framework to address evil banking behaviour. I am convinced that their book will be the starting point for a long and fruitful discussion.