J.P. Morgan: How to Prevent Another Similiar Loss

This month's $2 billion trading loss at J.P. Morgan Chase dashes any hope that we've resolved the instability of our banking system. How can we get banks to trade responsibly? When "too big to fail" banks generate huge losses, we all suffer. Legitimate businesses can't get credit. Taxpayers foot the bill for bailouts. Working Americans get laid off as scarce credit hobbles the economy.

Some experts clamor for more regulation. Better rules are definitely needed, but rules are not enough. We can make more progress, more quickly, by changing the incentives that motivate traders and senior bank management.

Compensation systems drive behavior. If career survival and advancement depend on taking dangerous risks, then employees will take dangerous risks, regardless of regulations. Even employees who know better and genuinely want to do the right thing can get caught in the whirlpool of bad incentives that suck everyone down.

When Bad Incentives Lead Good People Astray

NYC - Financial District: Morgan Guaranty Trust BuildingRemember what happened to Arthur Andersen? It's a good example of incentives leading basically good people to do bad things. Arthur Andersen was one of the largest and most respected auditing and consulting firms before it imploded due to its failure to point out the problems in Enron's financial statements. Of course, Andersen blamed a handful of "bad apples" rather than acknowledge a systemic problem.

Lapses like this are caused by the way people are compensated and promoted. If you are the lead partner on a major audit client, your bonus (not to mention your continued employment) depends on how much income you generate from your account. Moreover, your client's CFO understands this and knows how much leverage he or she has over your firm as a result.

Now comes your client's CFO to ask you to sign off on a sham transaction. Let's say it's for a new shell corporation designed solely to hide losses from investors. The CFO winks and implies that your consulting billings could either be doubled or cut in half next year depending on whether or not you approve the dubious transaction. It's easy for the CFO to shift the work around because there are many well-qualified consulting firms to choose from. You know in your head and in your gut that the transaction is wrong. But will you put your bonus at risk?  Will you put your job at risk?

Few auditors can resist intense pressure to approve a fraud. Good, honest people—people who know the difference between proper books and cooked books (or between honest credit ratings and inflated credit ratings)—succumb to pressure. People do what they need to do to keep their jobs and get their bonuses.  "As long as the music is playing, you've got to get up and dance," admitted Charles Prince, head of Citigroup in 2007.

To get better banks, we must incentivize people to be better bankers. We must structure compensation so that the traders (and the people they report to, all the way up to the top) are incentivized to be smart and responsible with their risk taking. A good way to do that is to take a portion of the salaries, bonuses, and stock options, and instead of paying them out in the year they are earned, spread them over a period of time, say over five years. (This is similar to the way stock options vest.) Each trader and executive would get 20 percent of their bonus each year. However, if the bank gets into trouble to the extent that it needs a taxpayer bailout, or is ordered to correct a material misstatement in its accounts, all of the vested but unpaid layers of bonus money would be forfeited before taxpayer funds are spent. This deferred compensation structure would create a strong incentive not to crash the bank. It aligns the bankers' incentives with what society needs from banks: stability, widely-available credit, and no bailouts. It does so simply, without additional taxes, and without capping what banks can pay their top traders and executives.

More Than Regulation

Some say regulation is a sufficient answer. But it's tough to regulate the highly complex transactions that dominate modern finance. The people inventing new instruments and trading strategies are very smart, very creative, and they have vast budgets for lobbying. The regulators trying to keep up with them are underpaid and overworked. Worse, they may hesitate to blow the whistle because they hope for a career on Wall Street after they complete their stint in Washington.

Let's strengthen the regulations as much as we can. But ultimately the impact of regulations is limited. It will take better incentives to get a better result.

(A version of this was posted earlier at usnews.com)

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