The Personal and Professional Responsibility of Investment Bankers
Claire Hill
Richard Painter
Abstract
Banks can contribute substantially to economic growth and other social advancement.
But they can also cause economic collapse and ensuing widespread misery. Most
recently, in the years leading up to 2008, a breakdown in personal responsibility in the
investment banking industry led to irresponsible business decisions in the United States
and global credit markets, with disastrous consequences for the banking system and the
economy as a whole. Despite the crisis and the ensuing regulatory crackdown, some of
this behavior continues. As recently as last month, one of the largest global banks, UBS,
lost more than $2 billion to unauthorized but apparently unsupervised activities of a
“rogue trader” in London. In Europe, investment bankers allegedly helped at least one
sovereign borrower, Greece, conceal from the European Union (and from markets
generally) the extent of its borrowing. Because of the irresponsible way in which
European sovereign debt was handled by bankers as well as politicians, the world may
face yet another financial crisis.
We cannot satisfactorily address this breakdown in personal responsibility with
regulation alone. Regulation is simply too blunt an instrument. When it is too specific, it
provides a roadmap for crafting loopholes. By precisely specifying what is prohibited,
the rules suggest what might be permitted. The alternative is more breadth, in the form of
standards. But these can be too broad. Standards can give regulators considerable
discretion to decide which behavior they would try to curtail -- discretion that could be
abused. Regulators might try to curtail desirable conduct, or fail to curtail undesirable
conduct. Whether regulation takes the form of rules, standards, or some combination of
the two, it cannot react quickly enough to deal with new and potentially dangerous
financial innovations such as derivative securities, collateralized debt obligations, and
synthetic swaps. Ultimately, regulation by itself cannot define what we want bankers to
do or what we do not want bankers to do; it cannot get bankers to do what they should do.
Society needs to focus more directly on promoting an ethos among bankers of doing what
they should do regardless of whether it is legally required, and not doing what they
should not do whether or not it is legally prohibited. We need to use a mix of regulatory,
social and other tools to encourage people with appropriate psychological dispositions,
risk preferences and personal priorities to go into banking and to act responsibly once
they are there (and, as importantly, to discourage those with inappropriate dispositions,
risk preferences and priorities from becoming bankers). We also need to reinforce the
concept of banking as a profession, with bankers as professionals having the individual
and collective responsibilities of professionals. These responsibilities extend to other
bankers, to clients, to the financial system and to society as a whole in much the same
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way as lawyers, doctors, accountants and other professionals have professional
responsibilities in their lines of work.
This book thus is not about banks as much as it is about the people who run banks. We
aim to bring bankers closer to a better understanding and a more consistent practice of
their personal and professional responsibility. The history of personal and professional
responsibility of bankers is cyclical, like banking itself. Sharp dealing and irresponsible
risk-taking cause a shock, and for a time, give way to more sobriety. Soon, memories
fade, and the supercharged search for new ways to seek profit begins again. In recent
years, the pendulum swung much too far in the direction of unconstrained self-interest;
the result was disastrous. The global scale of banking and the growth of complex
financial instruments make the cycles of irresponsibility that much more perilous as the
world’s financial systems have become increasingly interdependent. The future of private
sector banking could depend upon finding a way to establish and reinforce a baseline of
professional and personal responsibility that will govern banker behavior; if banks and
the economy continue on their present trajectory, the pressure to nationalize banks may
be strong, and ultimately, acceded to. This book argues that we need personal and
professional responsibility to constrain self-interest, and suggests specific ways of
accomplishing this goal.
In the years leading up to the recent crisis, personal responsibility collapsed on several
fronts. Bankers’ loyalty to their firms diminished. Bankers caused their own banks to
take enormous risks; indeed, Bear Stearns and Lehman Brothers became insolvent
because of the risks taken by their bankers. Bankers’ personal responsibility to their
banks’ clients and to third parties also declined. In contravention of its own rules,
Goldman Sachs bankers allegedly concealed from some of Goldman’s clients that the
securities and securities-based swap agreements Goldman was selling them were
designed to plummet in value. Citigroup has just paid a $285 million fine to settle
charges that it marketed to its clients a financial instrument that it had structured to yield
losses—losses from which Citigroup could profit, in addition to profiting from fees for
structuring the instrument. J.P. Morgan paid $154 million to settle similar charges.
Goldman bankers also allegedly helped the government of Greece hide Greece’s high
debt load from the European Union as well as from investors in Greek bonds. Other
sovereign borrowers such as Spain, Ireland and Portugal were assisted by bankers who
made more money when entire countries as well as businesses and people borrowed more
money (deal size and trading volume are key determinants of bank profits). The
conservative banker who tells people to borrow less rather than more, and who is willing
to speak out against excessive leverage in the economy, receded to the background until
it was too late.
This breakdown in personal responsibility has been caused by changes in the business of
investment banking, the institutional culture of investment banking firms and by changes
in the legal organization of those firms. Trading for a bank’s own account is a far more
important part of many banks’ business today than it was thirty years ago. Because most
investment banks were then privately held and commercial banks were strictly regulated,
access to capital for speculative trading was limited. Although the Dodd-Frank Act of
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2010 imposes some restrictions on derivatives trading, bank lobbyists were successful in
avoiding an outright ban; speculative trading will thus continue to be important. Because
most banks today are publicly held corporations, the money used for trading belongs to
shareholders and creditors, not to the bankers themselves except to the extent they are
shareholders (modern bankers rarely share the economic interests of their banks’
creditors). Contemporary bonus-based incentive systems also have given bankers an
increased appetite for risk: the bankers get the upside from risk, but are insulated from the
bulk of the downside.
Proposed SEC rules on executive compensation only partially address this problem.
Indeed, a critical but underappreciated factor contributing to the breakdown of personal
responsibility is precisely that bankers are not exposed to much downside risk. Before
the 1980’s, many large investment banks were partnerships, and the partners were liable
if the banks did not have sufficient assets to pay their creditors. Once investment banks
became corporations, bankers ceased to be liable for their banks’ debts; when their banks
borrowed too much money or used it recklessly they had less reason to care.
Personal responsibility has also broken down because the banking culture now
encourages bankers to focus more on their individual successes rather than on their
banks’ overall financial performance, financial stability, reputation and position in
society, and long-term client relationships. Bankers no longer typically make a career at
one bank; rather, they may move from bank to bank, increasing their compensation as
they go. Moreover, traders, whether they stay at one bank or move, often work alone or
in very small groups and are rewarded for their individual successes as much or more
than the successes of their firms.
Personal relationships between bankers have broken down as well. These include
relationships between bankers working in the same firm, between bankers in different
firms who compete for business but also know each other socially, and between bankers
and their customers. Regional banks that emphasize personal relationships within a
community have been swallowed up by national investment banks and broker-dealer
affiliates of commercial banks, and national investment banks have gotten bigger and
expanded into different lines of business. Indeed, the biggest banks operate on a global
scale. In the increasingly impersonal world of modern finance, investment bankers are
unlikely to have social ties to the persons and entities whose money is at risk, such as
their firms’ creditors, equity owners or customers; they may deal with the same people on
different occasions, but their narrowly professional. This impersonal nature of banking –
and particularly the impersonal nature of the trading operations that are the epicenter of
most banks -- minimizes what might otherwise be empathic constraints on banker
behavior. Imposition of risk on other people and institutions is depersonalized. In this
business and social setting it is more likely that highly competitive behavior that takes
advantage of others’ weaknesses will be seen as acceptable.
All of these influences on behavior operate not only at an individual level, but also at a
group level: group dynamics have arisen within banks and in the banking industry that
emphasize competition on alignable metrics. Bankers try to outdo one another in
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measures that lend themselves readily to comparison such as rankings for profits, deal
volume, and of course compensation.
Related to this change in ethos is a change in what skills bankers need to do their jobs.
Bankers used to deal with comparatively simple debt or equity. “People smarts” not
“academic smarts” was the kind of intelligence that made for a successful banker. Today,
banks deal with financial instruments so complex and abstract that they are designed by
finance and mathematics PhDs using computer programs and mathematical models, and
require such programs and models for their use. Many of these instruments represent
complicated bets on the performance of assets owned by others rather than direct
investments in capital markets. The complicated and in many cases synthetic nature of
these instruments, and the process by which they are developed, further depersonalizes
what bankers do, and promotes mechanized and atomistic competition disconnected from
tangible economic benefits to a particular business enterprise. Financial product
designers with highly abstract academic intelligence are sold by a sales force trained in
sound bites. The sales force does not understand the products they are selling; neither do
many of the investment managers who are buying them. Neither is inclined to admit their
lack of understanding. Wall Street’s new “meritocracy,” convinced that human
intelligence could solve all problems, came to believe that bankers could conquer or at
least control financial risk, just as medical researchers conquer disease and engineers
break new barriers in computing speed. Banking, when understood as a science rather
than as a clubby network of personal relationships, would create wealth for society, and
for the bankers themselves, that far exceeded the modest accomplishments of their stuffy
and less intelligent predecessors. Some commentators joined the bandwagon, celebrated
the new intellectual power of Wall Street and its products , and a few even endorsed the
view that in the new economy, business cycles had become a thing of the past.
These developments are closely tied to bankers’ view of society and their role in it.
Bankers have always viewed themselves as important parts of the business and social
community. But their sense of identity has changed. When bankers viewed themselves as
pillars of the business and social establishment, they were usually constrained from
advancing their self-interest too ostentatiously or single-mindedly. Competition was
always present in banking and in other lines of business, and some bankers would cheat
each other and their customers. There were, however, powerful incentives for bankers to
cooperate with each other and to instill loyalty in their customers. Bankers also had to
appear to serve a broader social and economic interest-- at least that of the upper levels of
society that comprised their customer base and many of their social connections. Overt
self promotion and greed were frowned upon in banking circles that prioritized loyalty to
institutions and groups; the institutions and groups may have been quite exclusive, but at
least extended beyond the self. By contrast, the modern banker is more focused on
promoting himself – and occasionally herself -- in society by competing against other
economic actors in society. The emphasis is on individual victory even (and perhaps
particularly) if it is obtained at the expense of the group. . Bankers, once dominated by
an ethos of conformity, are now known for their obsession with how their individual
accomplishment stacks up against that of their peers. A banker who beats the system
rather than conforming to it now may get a significant identity and status payoff that
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complements and sweetens his monetary payoff; these payoffs may be higher the more
his gain is others’ loss. Once collective success of a group is no longer as important as
individual success, bankers’ most celebrated extracurricular activities, change from
those associated with collective identity – social clubs and country clubs, prep schools
and colleges, family connections, etc. -- to those perhaps most often associated with
individual conquest: rapid acquisition of money and material goods. The celebrated
approach to sex also becomes focused not on long term relationships but on individual
“accomplishment” in the form of adventure. As Michael Lewis put it in his 1989 book
about Salomon Brothers, Liar’s Poker, the banker who emerges from this cutthroat
competition victorious has achieved the coveted status of “Big Swinging Dick.”
Whatever self-centered and snobbish behavior bankers exhibited in an earlier era, they
were then sufficiently grounded in the social fabric of the business community and its
inherent conservatism that such terminology would not have come to mind. It does now.
It’s not just these and other external factors that affect banker behavior – internal factors
play an important role as well. Bankers’ assessments of risk and reward reflect many
cognitive biases, fallacies and preferences explored extensively in psychological
research. These include over-optimism bias, confirmation bias, the “hot hand” fallacy,
and preferences for risk in certain contexts. Finally, physiology may play a role: recent
research provides evidence for a link between testosterone levels and risk-taking.
Despite all the emphasis on diversity in hiring and promotion, women are still very much
underrepresented in banking. Ironically some aspects of the older business model –
including emphasis on caution and collective success as well as “sociability” of bankers - might have brought more women into the field. Instead, both self-selection and the
selection process in banks favors those who are psychologically suited to an environment
of risk preferring behavior (mostly men, and also some women) and disfavors those who
are psychologically suited to an environment that emphasizes conservatism and tradition,
social connections, personal reputation and collective responsibility.
In sum, we view the 2008 financial crisis and continuing problems in the industry such as
the 2011 trading scandal at UBS as a failure of personal responsibility on the part of
investment bankers as individuals. We differ from the many academic and policy
discussions that focus more on banking institutions, characterizing the crisis as a failure
of institutional responsibility and the solution as increased regulation of institutions. We
take no position as to the specific contours of bank regulation. Rather, we argue that
effective financial system reform requires that bankers accept personal responsibility for
what they do and how it affects society. Bankers must accept personal responsibility for
the risks they take, the way they treat their customers and the consideration they give to
third parties affected by their actions and to society as a whole. If the banking system is
to work, banking must be regarded as a profession whose professionals have duties and
responsibilities to people other than themselves and their employers.
In this book, we will explain why personal and professional responsibility is important in
banking, how it was addressed in the past, and how and why we have failed to address it
in the present. We will also suggest specific ways in which more personal and
professional responsibility could be brought to the investment banking industry.
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We propose several remedial measures. Many of these measures could be imposed by
banks’ boards of directors, perhaps with encouragement from bank clients, without any
legal mandate. Some of these measures could be reinforced with regulatory changes that
encouraged banks to change personnel practices, executive compensation systems and
lines of business in a direction that promotes personal and professional responsibility of
individual bankers. A few of these measures might have to be imposed by regulators if
market forces in the industry do not bring about change fast enough to protect our
economic system from another banking crisis.
Some of our measures are particularly aimed to encourage people to become bankers who
have risk preferences and professional priorities suitable for the field, and encourage
people with risk preferences and priorities that are not suitable for banking to do
something else. We want to encourage only responsible risk taking. Therefore, we
propose that the highest paid bankers be required to assume some personal liability for
the debts of their firms, whether through guarantees, joint venture agreements or
assessable stock. We think that the movement away from general partnerships and
unlimited personal liability in the largest Wall Street investment banks was a mistake,
perhaps a catastrophic mistake. Returning to partnership form is not feasible, but through
contract, bankers can have some of the liability they used to have as partners.
Second, we favor a change in bank hiring standards. We are not convinced that the
“meritocracy” that characterized Wall Street personnel decisions in recent decades
delivered better bankers than an older emphasis on sociability and social connections.
Hiring standards that focus more on quantitative skills and ingenuity and less on social
skills and commitment to preservation of a socio-economic system probably gave us
bankers who did more harm to society than their predecessors. We do not suggest
returning to the ethnocentric clubiness that characterized banking in a former era, but we
do suggest that there should be a greater emphasis both in business schools and in banks
themselves on the socialization of investment bankers. More bankers should see
themselves as part of a banking system and a broader economy in which they take
collective pride rather than seeing themselves as lone agents bent upon beating the
system. Bankers should openly discuss the relationship between their work and their
religious values or a secular philosophy that gives meaning to their lives, although this
discussion also should be conducted responsibly with awareness that any discussion of
“values” can be misused. Religion for too long was a basis for discriminatory hiring and
promotion practices in banking and even today bankers and investors are vulnerable to
“affinity fraud” (the Arizona Baptist Foundation collapse in 2001 and the Madoff
pyramid scheme that collapsed in 2008 illustrated how religious identity can be misused).
Still, most people have philosophical commitments to something other than themselves
and their own material self interest, and our banking system will suffer if, when people
become bankers, they are encouraged to leave those commitments at the door.
Third, we think that banker compensation should overall be lower, and be less sensitive
to performance. Higher compensation (particularly “success” based bonuses) do not
appear to make for better bankers and probably attract people to banking whose talents
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and risk preferences are best used elsewhere. Our economy has a place for people with
big ideas and big ambitions who are willing to take risks, whether wildcatting for oil or
investing in new medical technology or new software. These people should, when
successful, become multimillionaires or even billionaires, but most of them shouldn’t be
bankers.
Banking has a very different function, which is to monitor the time, manner and
magnitude in which more speculative enterprises gain access to investors’ capital. When
banking itself becomes speculative, this moderating influence disappears and there may
be no social, economic or political force other than government regulation to moderate
banking itself. Lowering bankers’ overall compensation may actually make for better
bankers, and encourage persons whose talents, ambitions and risk preferences are best
used elsewhere to go elsewhere. Bringing some measure of job stability to the industry
also might help (for example, three to five year employment contracts for new recruits
would encourage more cautious people to consider careers in banking).
Our next proposals concern ways in which the banking business can be structured so as to
encourage banker responsibility.
Our fourth proposal is that the banking business be structured so that bankers are able to
make healthy profits providing a defined service to capital markets, such as underwriting
for issuers of securities, mergers and acquisitions for business clients, portfolio
management, and brokerage services. Not all firms need to provide all of these services,
and the fact that they may conflict with each other should be acknowledged so that firms
that provide only one or two services are respected for the singularity of their
commitment. They should also be able to make money. Efforts to make client-centered
areas of banking more competitive and to squeeze profit margins – such as the abolition
of fixed brokerage commissions in 1975 and the introduction of shelf registration of
securities in 1981 – may have backfired in that investment banks increasingly turned to
diversification and their own trading operations as profit centers and deemphasized client
relationships. Banks should instead be encouraged to specialize in those areas of work
where they can convince clients they do – and get paid for -- a good job.
Our fifth proposal is that a significant amount of investment banking should be local,
because local bankers more often have regular social and economic interactions with the
people and organizations that are affected by their work. Complicated regulatory
schemes -- arguably including parts of the Dodd-Frank Act – unfortunately may raise
compliance costs for regional banks which cannot afford legions of lawyers and don’t
enjoy the economies of scale of their larger counterparts, thus providing advantages to
larger banks and encouraging further consolidation that results in banks “too large to fail”
and more willing to take risks. Regulatory, tax and other incentives instead should be
used to promote regional banking and reverse the trend toward large money center banks
that are remote from the persons and organizations they affect, and that at the same time
are too big to fail.
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Our final proposals concern increased roles for others, specifically banks’ creditors and
for their service providers.
We propose that creditors should get certain rights if a bank’s debt/equity ratios exceed
certain levels. They might, for instance, get a representative on the board, and mandatory
say on pay.
Our seventh and final proposal concerns ways professional service providers should
support rather than undermine bankers’ personal and professional responsibility. For
example, lawyers paid by the hour or by the deal to assist bankers with working their way
around regulations, or providing opinion letters on dubious transactions, often have a
counterproductive role. A step in the right direction might be for bank directors to insist
on paying these lawyers “conditionally”; if the banking client both violates the relevant
law during the lawyers’ watch and becomes insolvent within a certain period of time, all
legal fees earned within a specified time frame would be disgorged. Contingent and
conditional fees are common in the practice of law; the banking lawyer’s fees should be
contingent on something other than whether the particular bank manager who hired the
lawyer is presently pleased with the lawyer’s work. Furthermore, lawyers should have
more of a duty to communicate with senior management and boards of directors more
often and in more detail, not just when "reporting up" is required under SOX 307.
Certainly, reporting should be required if a transaction is large, and, even thought not
clearly a violation, represents a ‘close call. ’ We note in this regard that the board of
Lehman Bros. apparently was not told about Repo 105.
We recognize fully that ‘the devil is in the details’ – that our proposals as stated here are
starting points for further discussion. We recognize as well that the success of our
proposals will be limited they do not affect the corrosive ethos of irresponsibility that led
to the crisis. In particular, proposals for less limited liability can inspire assetsheltering, proposals for creditor say when debt/equity ratios change invite gaming the
ratios, different compensation will, it will be said, send the more talented people to hedge
funds or another jurisdiction, and ethics education can be ‘going through the motions’
without any real substance. But in tandem, and with a broad discussion, the ethos can be
influenced too, we hope, and the regulatory and ethos changes could be complementary.
The ethos we think desperately needs changing is one which allows bankers to boast
about allowing their clients to conceal their debt; we will know we have had some
success when such behavior, instead of being boastworthy, would instead make bankers
fear social sanction and perhaps legal sanction as well.
Chapter 1
The Collapse of Personal Responsibility:
Deception, Disregard for Others, Lack of Accountability and Reckless Risk-Taking
At the earliest age, children are taught about honesty as well as regard for persons besides
themselves. Another of life’s lessons is accountability: one cannot simply walk away
from the consequences of irresponsible conduct. Unfortunately, these lessons are
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sometimes never learned. Sometimes these lessons are learned and then unlearned in
one’s professional training or work environment. Sometimes they are learned and
ignored.
The principal concern underlying this book is that investment bankers need to be honest
with themselves and with others, they need to understand the impact of their conduct on
other persons and they need to take responsibility for the consequences of irresponsible
conduct. Four aspects or irresponsibility are explored in this chapter – deception,
disregard for others, lack of accountability and reckless risk-taking. The financial crisis
of 2008 was an example of how devastating irresponsible banking can be.
Deception
“Enron loves these [pre-pay] deals as they are able to hide funded debt from their equity
analysts because they (at the very least) book it as deferred rev or (better yet) bury it in
their trading liabilities.”
Email from one Chase banker to another, November 25, 1998,
Dishonesty has been a critically important part of the crisis in personal responsibility in
banking. Bankers have been too willing to lie, tell half truths, lie by omission, and help
others lie. Bankers have lied about the risks they take, their banks’ financial condition
and the products they are selling to clients, as well as about the financial condition of
clients.
Some of these lies were to the shareholders and creditors of investment banks, as
evidenced by the Lehman Brothers “Repo 105” transaction and Lehman’s transactions
with Hudson Castle, an entity specifically intended to take poorly performing assets off
of Lehman’s balance sheet. Other lies were to customers and persons bankers transacted
with. For example, Goldman Sachs was accused by the SEC of telling clients that
financial instruments Goldman was selling to them were designed to do well, when the
instruments were actually designed to fail. In yet other instances, bankers helped their
clients to lie, for example when bankers in the United States helped the Greek
government lie to the European Union and to its bondholders and Enron lie to its
investors. In the case of Enron, bankers helped the company paint a wholly false
financial picture, complete with fake income and cash flow.
Why do bankers behave this way? One reason is that bankers don’t worry much about
liability. Exposure to civil liability for securities fraud has been reduced in the past
several decades and there is little or no liability in private lawsuits for aiding and abetting
other peoples’ fraud. Many transactions are private rather than public; antifraud statutes
apply, but there are few affirmative disclosure obligations. Another reason is that
bankers’ ties to the people they deal with have changed. Bankers are less likely to have
personal relationships with people from whom they raise capital, and the people they do
deal with regularly are more likely to accept a code of ethics in which honesty is not a
priority compared with other things that may favor dishonesty, such as profits and deal
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volume. . Yet another reason may be that for a generation that grew up on Vietnam,
Watergate and other scandals, as well as the insider trading scandals of the 1980’s, lying
and watching other people lie has become an accepted part of life. Even in academia, a
profession that should value honesty, suspicion of “absolute truth” permeated academic
commentary in the 1980s and 1990s. .
A personally responsible approach to investment banking would make honesty a central
value, if not the most important value, in the business. Telling investors and customers
what they would want to know should be more important to the responsible banker than
mere technical compliance with securities disclosure laws. Affirmative disclosure should
be as important as avoiding affirmative misrepresentations. At the end of a transaction,
both parties should feel that, regardless of the outcome, they were told everything they
should have been told by the other party; employees, shareholders and creditors of
investment banks also should feel that they are being told what they should have been
told to make their own decisions. Similarly, bankers have a responsibility to tell the
complete truth about what they are doing to regulators, Members of Congress, and other
parts of the government. Bankers should care about whether the public trusts them.
Lack of Regard for Others
"The public be d—ned.”1 William Henry Vanderbilt to a reporter requesting an interview
I am “doing God’s work” – Goldman Sachs CEO Lloyd Blankfein to the London Times
A second aspect of irresponsibility has been investment bankers’ lack of regard for
others. Too many investment bankers act as though they do not care about the impact
their behavior has on others. Their unit of account is the self, with the firm being
second. Client interests are third place. The well being of the financial system and
society as a whole is a distant and largely irrelevant fourth consideration.
A comparison with the legal profession is illustrative. Whereas lawyers work in a
profession that at least purports to put the interests of the client and the interests of the
legal system ahead of those of the individual lawyer and his firm, investment bankers do
not articulate (other than in sales literature, advertising and sometimes in annual reports)
a professional commitment to interests other than their own. For most bankers – with
the possible exception of brokers in a fiduciary relationship with customers -- there is no
code of professional ethics that requires them to prioritize clients’ interest and the
interests of the banking system. Lawyers do not always practice what they preach, but at
1
William Henry Vanderbilt, president of the New York Central Railroad and numerous other railroads was
widely reported to have uttered these words on October 8, 1882: Vanderbilt was in his private railroad car
traveling when Clarence Dresser, a reporter, entered Vanderbilt’s car in Chicago and demanded an
interview vaguely referring to the public’s right to know. Vanderbilt angrily blurted out his response, which
was immediately published in newspapers around the United States.
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least they preach it. Investment bankers do not preach it very much and probably practice
it even less.
Only after the financial crisis of 2008 did investment bankers, most notably the senior
officers of Goldman Sachs, forcefully describe their work itself as a public service.
Their claim to a public mission lacked substantiation and became even less credible as
yet further scandals unfolded and it became obvious how singularly focused investment
bankers had been on self interest even at the expense of others. Claims that meritocratic
banks such as Goldman Sachs promote democratic ideals by giving talented persons of
all backgrounds a chance to succeed in finance ignore concerns about how these bankers
succeed. Lloyd Blankfein’s Horatio Alger story only goes so far, and says nothing about
the fate of the people he left behind who may be among the most vulnerable in a world of
irresponsible lending, vacillating credit conditions and economic collapse.
The trading business that dominates so many large investment banks is particularly
problematic in this respect. It promotes the ethos, and reality, of advancing one interest –
perhaps that of the trader himself, a group within a bank, or the bank itself- at the expense
of others. The notion that an investment banker has a professional obligation to the
stability of the banking system or to society as a whole is almost never mentioned, much
less considered as a factor when traders make decisions.
Globalization of investment banking is another factor. Globalization often puts the other
side to a transaction thousands of miles away rather than within a more cohesive business
and social circle, and reinforces the notion that investment banking is a game in which
every man plays for himself. Norms develop in the community in which it is fair play to
take advantage and engage in sharp dealing. With increasingly complex and less tangible
financial products investment bankers also may not fully understand the risks they are
foisting upon others. And even if they do understand the risks ‘intellectually’ they may
not understand them viscerally in a way that makes them think twice before imposing
those risks on others.
Ironically, this crisis in regard for others occurred during a time – the 1990’s and early
years of the twenty first century – of enormous philanthropic commitments by investment
bankers and other leading business people. One issue we will explore is whether these
philanthropic commitments – often a way of boosting a donor’s ego and boasting of
professional success – were a substitute for running a business in a responsible manner
that considers the interests of others. Compartmentalized ethical systems separated the
ruthless self seeking in investment bankers’ professional lives from the more beneficent
goals they may have had for their personal lives, with charity being a conspicuous outlet
for the latter. In the worst cases, such as Bernard Madoff, charity was also an instrument
for achieving selfish ends.
Personally responsible bankers ideally would gravitate toward lines of business that are
intended to result in a win-win payoff rather than a zero sum game. Win-win is
presumably the essence of capital formation, investments and other traditional aspects of
investment banking. Win-win is what makes banking, and business in general, different
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from a casino. Trading transactions can be problematic from this perspective, but they
don’t have to be. Trading also can meet the mutual benefit standard, if both parties are
informed of the risks involved, and both parties have a good business purpose for
transferring the risk from one of them to the other. Bankers should not engage in
transactions in which they, or their client, are taking unfair advantage of other people’s
lack of knowledge, gullibility or other weakness. Bankers should act with due regard to
their own and their bank’s stake in long-term relationships.
In many businesses, a tension exists between a business person’s self-interest and that of
others, including the greater society; there may also be a tension between the person’s
self-interest and that of her firm. Decision makers often struggle with competing
objectives. Lawyers, for example, face a tension between client advocacy and the
professional obligation to support the truth finding function of a tribunal. What is
unacceptable – particularly for a profession like investment banking, that has an
enormous impact on society as a whole -- is for tension between competing objectives to
be resolved exclusively in one direction, a narrow view of the banker’s own self interest.
Businesses should not be seeking to profit at society’s expense; indeed, their activities
should make society better off. An investment bank has a social as well as an economic
justification if it is committed to facilitating access to capital for businesses, access to
sound investment opportunities, enhancing the growth and stability of the financial
system, the well-being of the community and the profitability of its business for the
benefit of its employees and its owners. A responsibly run investment bank will
recognize that in the long term these goals are not inconsistent. In sum, the “greed is
good” ethos may have a long history on Wall Street, but it has not been a happy one.
Fortunately, this ethos has sometimes been balanced by an ethos of individual and
collective responsibility. Personally and professionally responsible investment bankers
understand and act upon an appropriate balance between self interest and the collective
good.
This chapter will also discuss a topic that relates to both lack of honesty and lack of
regard for others -- how investment bankers find and exploit loopholes and use other
means of manipulating financial appearances. For example, bankers created currency
trades and derivative securities that allowed Greece to hide its insolvency while
technically complying with European Union debt limitations. Bankers were being
dishonest, showing no regard for Greece’s creditors or the EU member states that would
in all likelihood bail out, or try to bail out, Greece.
Yet another example of “loophole banking” is the way banking lobbyists used political
pull to create a legislative loophole for security-based swap agreements in 1999 and
2000. That new law exempted security-based swap agreements from the definition of
“security” and explicitly prohibited the SEC from promulgating regulations intended to
prevent fraud in such agreements. Investment bankers then used this loophole to create
an enormous market in unregulated security-based swap agreements- a market that was
apparently characterized by fraud of precisely the type that Congress had told the SEC it
could do nothing to prevent. Bankers concerned with the well-being of others probably
12
never would have asked Congress to create this loophole; in any event, they would not
have exploited it to wreak havoc with swap agreements. Finally, bankers convinced the
SEC in 2004 to adopt a change to its “net capital rule” created in 1975 for broker-dealers.
The 2004 rule change allowed five firms — Bear Stearns, Lehman Brothers and Merrill
Lynch plus Goldman Sachs and Morgan Stanley — to assign high valuations to assets on
their balance sheets using mathematical models. As a result, these firms could
substantially increase their leverage.2 After the debacle of 2008, three of those five firms
are no longer in existence. The bankers who exploited this loophole to avoid capital
requirements and leverage balance sheets destroyed their own firms and did great damage
to the lives of the thousands of people who depended upon those firms for a livelihood.
Empathy – concern for others – would have suggested a far more cautious course of
action. Lehman Brothers and the other large Wall Street banks were for many of the
years after the disaster of the late 1920’s and 1930’s run profitably yet in a manner that
showed far more respect for the impact of their activities on others. The SEC did not
purport to regulate their safety and soundness, yet for the most part these banks were safe
and sound. The older generation of bankers had experienced what can happen when
banks are run irresponsibly, including the shame that comes to an industry that inflicts so
much misery on fellow human beings (they had watched their elders hauled in front
Congressional committees demanding remorse rather than arrogant claims to be doing the
Lord’s work). For reasons that are explained later in our book, things changed beginning
in the 1980s’ and bankers once again engaged in many activities heedless of the impact
of those activities on others. What one is allowed to do and what one should do are
sometimes two very different things.
Lack of Accountability
“When things go wrong it’s their [the shareholders’] problem. . . It’s laissez-faire until
you get in deep shit.” Former Salomon Brothers CEO John Gutfreund in an interview
with Michael Lewis discussing limited liability in investment banking and the government
bailouts of 2008.
A third aspect of personal responsibility is accountability or willingness to accept the
consequences of one’s actions.
2
The 1975 rule was designed to assure that broker-dealers could meet obligations to customers and other
creditors. The rule requires firms to value their securities at market prices but also to discount those values
-- applying a so called “haircut” -- based on the risk characteristics of securities in their portfolio. The
haircut values of securities held by a firm are then used to compute the "cushion" of required liquid assets
for purposes of the net capital rule. The 2004 rule change permitted the largest broker-dealers with net
capital of more than $5 billion to apply for exemptions from the traditional method of calculating the
"haircut" and instead use mathematical models to compute haircuts on securities. This made it easier for
these firms to meet the net capital requirement by claiming higher values for their securities. See 17 CFR
Parts 200 and 240, Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated
Supervised Entities; Supervised Investment Bank Holding Companies; Final Rules (June 21, 2004), 69
Federal Register 34428 (stating that “These amendments are intended to reduce regulatory costs for brokerdealers by allowing very highly capitalized firms that have developed robust internal risk management
practices to use those risk management practices, such as mathematical risk measurement models, for
regulatory purposes.”).
13
If you break it, you pay for it.
Unless “it” is a limited liability entity, like Lehman Brothers, Bear Stearns, Merrill Lynch
and just about every other major investment bank on Wall Street since general
partnerships were abandoned by the industry in the 1980s. Then somebody else pays for
it – creditors, employees. If “it” is too big to fail, the government —ultimately, of course,
the taxpayer- also pays. The banker who broke the bank usually has an opportunity to
convert at least some of the enormous compensation he was paid by the bank into cash
and leave, with the rest of his assets intact. Like a child who quickly flees a store after
breaking merchandise, the banker keeps whatever money is in his “pocket” and avoids
the consequences of his actions.
Our point here is not that limited liability is inherently irresponsible. As explained more
fully below, corporate law has mechanisms for making managers accountable for their
actions, at least to shareholders, and in some circumstances, to creditors. Our point is
that limited liability and personal responsibility can and do clash, and that this clash has
been particularly pernicious in the field of investment banking. Indeed, as explained
more fully in Chapter _2_of this book, the change, mostly in the 1980s, from partnerships
to corporations on Wall Street coincided with an escalation of irresponsibility among
investment bankers. This was not a mere coincidence, although limited liability was not
the only cause of irresponsible banking practices.
Personal responsibility does not require unlimited liability: A banker can act with
personal responsibility without being personally and unlimitedly liable for his bank’s
debts. Personal responsibility does require, however, that the banker who makes
decisions about risk and other matters is required to pay at least part of the cost if those
decisions result in large losses. For reasons explained more fully in Chapter __ below, it
is not sufficient for the banker simply to forfeit most of the compensation he earned by
taking irresponsible risks. Adjustments to incentive based compensation only go so far in
reducing appetite for risk. At least some other personal assets should be at risk. Even in
the gaming industry, irresponsible gamblers can, and often do, leave the casino worse off
than when they entered. This is not possible if only upside compensation is at risk. In
Chapter __, we propose two mechanisms by which bankers could be made personally
liable for losses suffered by their banks.
Reckless Risk-Taking
Reckless child (on bicycle): “Look Mom, no hands . . .”
Parent (talking to another child and pointing to child on bicycle): “Look Son, no brains.”
A fourth aspect of professional irresponsibility in banking has been reckless risk-taking.
The first three aspects of irresponsibility – dishonesty, lack of regard for others and lack
of accountability for the consequences of one’s actions – affected the way bankers
14
approached risk. The nature and degree of the risk itself is also important. Some risktaking is responsible, and some is reckless.
When Bear Stearns and Merrill Lynch collapsed, the government bailed them out with
taxpayer dollars and arranged marriages to other banks. Thousands of employees of both
firms lost their jobs. Lehman Brothers, by contrast was allowed to fail. Its employees
also lost their jobs. Its debts were estimated at $150 billion, much of which the firm’s
creditors will not be able to recoup. Credit markets froze up and the American economic
system headed toward collapse. The total cost to the government of bailing out the
financial sector is difficult to estimate, but it will probably cost hundreds of billions of
dollars. Even worse, the crisis drove the economy into its worst recession in decades,
destroying billions of dollars more in wealth and leading the reported unemployment rate
to climb to nearly 10%.
The firms that failed, were bailed out, or took enormous charges against their capital, all
had taken on enormous risks through exposure to mortgage backed securities,
collateralized debt obligations, and derivative securities. Much of this exposure was
taken with money belonging not to the firms themselves but rather, to their creditors.
The debt equity ratio for investment banking grew steadily in the 1990’s, and was
extremely high by 2008.
Senior executives of the banks were called before Congress to explain what happened.
None of them accepted personal responsibility for the risks they had taken in loading
their firms up with so much debt or making such risky investments. None of them
offered to pay out of their own assets a portion of the cost that had been imposed on
creditors and society as a whole. Many of them made excuses. Some had the arrogance
to claim that their business practices had been for a social good.
This chapter will discuss the risk-taking that precipitated the 2008 financial crisis: high
leverage ratios in investment banks; large portfolios of complex securities, including
‘synthetic’ securities, interconnected transactions among interdependent banks; bonus
driven investments, etc. The common theme is irresponsible risk taken by financial
institutions and the persons who made decisions for those institutions. Investment
bankers stood to make enormous gains; their firms and the greater society were exposed
to enormous losses.
This chapter will also explain and develop the distinction between responsible risk-taking
and irresponsible risk-taking. Ideally, responsible risk-taking would have a socially
beneficial objective, the risk would not be excessive in proportion to the expected social
benefit, the person or entity deciding to take the risk would have a significant downside if
the risk did not pay off, and other parties exposed to the risk would agree to bear it after
being given complete information that they could understand and use to protect
themselves.
Of course, responsibility in risk-taking is a matter of degree. These factors form a
continuum, with risk-taking that is obviously irresponsible at one end and risk-taking that
15
is obviously responsible at the other. We are not suggesting that investment bankers
should not incur risk to pursue profit; we are simply saying that they should not pursue
profit single-mindedly, heedless of the consequences to their firms and to others. They
“should not” do so because they have public responsibilities that go along with the
considerable power over public welfare that comes with their positions.
The first component of responsible risk taking, that there be an expected social benefit
from risk, is typified by the core mission that investment bankers traditionally have, of
raising capital for new business ventures. Bankers are presented with many ventures
seeking financing; they select those ventures that deserve access to public and private
capital, rejecting those that do not. They thus serve as gatekeepers to capital markets.
Investment bankers also have a role in assuring that relevant risks are disclosed to
investors before the capital raising process begins. Investment bankers furthermore help
assure the integrity and liquidity of secondary markets, including stock and equity
research, executing orders for brokerage customers, and to some extent trading on their
own account; historically, they engaged in such trading only when it did not interfere
with their other more essential functions (such is no longer the case). All of these
functions provide an identifiable social benefit.
The social benefit from investment bankers’ work may arise from the venture for which
investment bankers facilitate access to investors. For some ventures, there is a
potentially huge social benefit, for example ventures that seek to develop drugs to cure
cancer or a new technology for clean energy. Sometimes the social benefit is more
modest: some ventures simply seek to build a better “mousetrap” (or a better website or
better method for doing one’s taxes). A new product or service that people buy
willingly usually provides a social benefit.
Investment banks’ transactions can also provide a social benefit even if they do not
directly involve funding the end-user of capital. Consider the early mortgage
securitization transactions. Mortgages already made were pooled, and interests were
sold to investors. The result was that funds became available to make more mortgages,
and loan rates were equalized and lowered throughout the country. Securitizations of
cross-border cash flows enabled sound businesses in countries with high political risk to
get access to capital at low rates. The social benefits from these transactions might be
greater access to capital, market liquidity, or more efficient pricing. These latter types of
transactions, however, set the stage for other transactions that are potentially
problematic—that take on a life of their own separate from their social purpose,
especially where the transactions serve to facilitate risk taking as an end in itself or would
not have been done but for a banker’s bonus or other short term payoff. In these
transactions, the risks bankers take are less likely to have a social benefit.
The second component of responsible risk-taking is that the risk not be disproportionate
to the expected social benefit. This risk at issue needs to be assessed not only from the
perspective of the risk taker, but – because most risks have social externalities – also
from the perspective of society. It is, for example, a good thing for working families to
have access to mortgages they can afford, and some mortgage-backed securities further
16
this goal, but society can be far worse off if mortgage-backed securities allow many loans
likely to end up in foreclosure to be made. The social harm exceeds the social costs.
Regardless of whether there is a willing borrower and a willing investor in such loans, it
is personally and professionally irresponsible for bankers to facilitate them.
Responsible risk-taking requires that bankers take reasonable steps to inform themselves
of the potential social costs of risk relative to the potential social benefits from risk, and
act based on this information. At a minimum they should restrain from facilitating risks
when the expected social costs are far higher than the expected social benefits. As we
will discuss, some bankers did not inform themselves about social costs and benefits of
particular risks; others did, and acted to protect themselves (by shorting risky
investments) but not to protect others from the likely consequence of disproportionate
risk. When mortgage loan volume was rapidly increasing and underwriting standards for
the loans was rapidly decreasing, bankers should have realized that a dangerous bubble
was forming, and that the many borrowers with increasing loan payments would soon be
unable to pay or refinance their loans and thus would default. They also should have
realized that at a certain point, there would be no more plausible buyers for homes. Some
bankers might not have realized these things – again, they should have. Others did, but
nevertheless continued engaging in these transactions, hoping to make as much money as
they could before “the music stopped.”
The third component of responsible risk-taking is that the person or institution taking the
risk shares in it – e.g. will suffer a significant downside if the risk does not pay off. This
is where accountability – a concept discussed above – is important. While many
investment bankers had significant stockholdings in their banks, and lost a great deal of
money in the crisis,3 many did not. More importantly, many of those responsible for risktaking were insulated from a significant downside because even their worst-case scenario,
in which they lost a great deal of money, did not put at risk their personal assets outside
the bank. As we will argue, considerable evidence suggests that people can view
different portions of their assets differently, and have different risk preferences over those
different portions. As long as a banker will have enough money to maintain his high
standard of living even in the worst-case scenario, he may be willing to risk a large
amount of his net worth, particularly the portion acquired by taking similar risks. We
think that if bankers’ worst-case scenarios potentially compromised their standards of
living, they would have thought much longer and harder before incurring the big risks
that sank their firms and the economy-- they might very well have come to very different
conclusions and made different decisions.
The fourth component of responsible risk-taking is that those who bear the risk
understand it and consent to doing so. At the very least appropriate disclosure is
required. This is where honesty – another topic already discussed above -- comes in. But
disclosure is not enough. A common problem is that investment managers with short3
How much they “lost” depends of course on how we compute what they “had” – do we compute at the
peak of the market or at some lower valuation? There can be many defensible ways to approach this
computation, some of which would suggest that even bankers who “lost” a great deal still came out better
off than they been when they started working at their banks.
17
term time-horizons may “consent” to taking a risk where the risk is not suitable for the
people on whose behalf they are investing. Consider in this regard the concept familiar
from broker-dealer regulation, “suitability.” The suitability rule governs broker-dealers’
dealings with customers – a broker should not put an investor’s money into an investment
if the risk is not suitable for that particular investor. A concept like suitability should be
more broadly applied to investment managers. Some of the risks foisted off on
institutional investors were not acceptable because they were not suitable for the persons
who ultimately bore them. 4 Bankers failed to inform themselves as to who ultimately
would bear the risk. Is a risky instrument being sold to a public pension fund or
municipal government? Orange County, for example, incurred large losses on complex
securities sold to them by Merrill Lynch, which ultimately had to pay the county for some
of these losses. Taxpayers, not well-to-do investors, paid the price. Country services
suffered as well. Responsible risk-taking includes not foisting the possibility of huge
losses on parties for whom the risk is not suitable; and simply because a party purports to
be large and sophisticated does not mean that the ultimate bearers of risk are the same.
Of course, those bearing risks incurred in the banking sector also include more attenuated
parties such as neighbors of homeowners who default on risky loans. They also include
municipalities with vastly diminished property tax revenues because many home values
have plummeted and many homes are no longer occupied by people paying their real
estate taxes (and indeed, many homes are no longer occupied at all). We could
characterize all taxpayers as risk-bearers. We could also include all the people who
became unemployed because the economy failed. We could include most investors
because markets in general deteriorated after the Lehman bankruptcy in September 2008.
Investment bankers should not be expected to calculate all of these risks but they should
be aware of and consider them.
Responsible banking does not mean avoiding all or even most risk. Much risk-taking is
beneficial for investors, for the economy and for society as a whole. We seek to
articulate a concept of responsible risk taking based on these four components: the less
social benefit a risk has, the greater the extent of the risk relative to that benefit, the
smaller the decision-maker’s exposure to downside risk, and the less those who bear the
risk understand, accept, and can bear it --the more irresponsible the risk is.
As discussed in Chapter 2 below, the shift toward irresponsible risk has a historical
dimension. The 1980’s saw a move away from corporate finance as underwriting spreads
declined. This and other changes in the industry led to increased emphasis on trading for
a bank’s own account. The trader’s risk taking personality moved to the fore, as
illustrated in the 1980s by Michael Lewis’s well known book Liar’s Poker, about traders
at Salomon Brothers. Then came computerized trading programs and finally the
“virtual” trading markets for credit default swaps and other instruments that emerged in
the 1990s. Whereas many bets similar to swap agreements were unenforceable at
4
Congress in 2010 asked the SEC to study whether broader fiduciary obligations should be imposed, but
for many broker-customer relationships the suitability standard remains the norm. As discussed in the text,
banker behavior in the crisis would not be consistent even with the existing, more relaxed suitability
standard.
18
common law, Congress in the 1990s provided that they were to be enforceable while not
taking steps to regulate them until 2010. An enormous shadow market of swaps and
other synthetics instruments evolved, with highly paid investment bankers at the heart of
it.
As also discussed in Chapter 2, this personally irresponsible attitude toward risk has been
reinforced and fueled by the amount and structure of compensation in the industry: huge
amounts are paid for short-term results. Investment bankers took for their firms and for
others risks that were extremely high and that – unlike the example of investing in a risk
technology start up – offered little or no social benefit. They did so oblivious or
indifferent to the potential damage that could arise from the interconnectedness between
firms in the industry and the enormous social externalities of banks’ excessive risktaking. Some bankers acted illegally; others did not. Many, however, embraced risks
that were irresponsible. As we discuss above, personal responsibility involves not only
responsible risk-taking but also being truthful, acting with regard to the effects on others
and accepting consequences when those effects are harmful. Too many bankers behaved
irresponsibly. Bankers should have recognized that the risks they were taking were
dangerous to their firms, to the economy and to themselves; they should have acted to
avoid those risks.5
Chapter 2
The Breakdown of Constraints on Irresponsible Investment Banking
Why do bankers act the way they do?
Part of the story is self-interest of the sort hypothesized in the economic paradigm
reigning for a generation or two before the 2008 crisis, sometimes referred to as
“neoclassical economics.” The paradigm’s view of human nature can be bleak as well as
rigid: people advance their self-interest, even when doing so is contrary to others’
interests. Going further, the paradigm often assumes that advancement of self-interest
will often be contrary to others’ interests. The culmination is a normative assessment that
pursuing self-interest, at others’ expense, is “rational” and thus good. Most economic
5
Bankers take risks that lack most (and perhaps all) of the components of responsible
risk-taking in part because they are strongly motivated to take such risks. Their
compensation structures encourage them to do so, as do the expansive boundaries of the
markets – or virtual markets – in which bankers ply their trade. Since the mid-2000s,
there have been few “natural” limits to trading positions - bankers can keep creating new
opportunities to make side-bets on securities already in existence. Indeed, all a banker
needs to create a bet is two parties willing to take opposite sides. Bankers can take the
same “raw material” and re-package it many times over. Large fees are paid at the outset
to banks when transactions are structured, marketed and sold – fees that in substantial
part are then turned over to individual bankers. The results and effects of these
transactions may not be known for a while, and there is no assurance that the winners or
losers will be able to fund their “bets”.
19
actors are assumed to be rational. Departures from rational pursuit of self interest –
errors in judgment -- are assumed to balance each other out, so they don’t matter very
much.
This perspective was a sharp departure from the perspective of earlier economists, such
as Charles McKay in the mid Nineteenth Century and John Maynard Keynes in the early
Twentieth Century, whose paradigmatic economic actors were vulnerable to herd
mentality, market bubbles and similar phenomena rooted in sociology and psychology.
Errors in judgment were assumed to be systematic and substantial, not random and
insignificant. Greed in the scenarios these economists described often led to economic
actors’ downfall, as well as the downfall of entire economies.
Moreover, while these earlier economists acknowledged that people are often selfinterested, their neoclassical successors emphasized a particular, narrow, zero-sum type
of self-interest, and gave it normative heft. The neoclassical paradigm celebrated greed,
and didn’t fear the consequences of that celebration. Society was assumed to be better
off if everyone “rationally” sought to acquire the most “toys” – the credo became that
“whoever has the most toys at the end wins.”
As theories of economic behavior changed, actual behavior in the business world also
strove toward this ideal of “rational” selfishness. Many academic commentators
recognize that the paradigm is a caricature, but Wall Street has still been promoting it,
and promoting those who best fulfill the caricature as “winners” because they are
supposedly more rational – and of course more selfish – than their competitors.
Demonstrating shortcomings of the homo economicus paradigm is easy. We don’t take as
much advantage as we can and we don’t generally expect that others will either. When
we are asked for directions to a restaurant, we try to answer accurately, and we expect
others to do so, even though we might have an interest in giving inaccurate directions and
might think a person we asked might also have such an interest. Perhaps we, or they,
work for a competitor, for instance. But, as the philosopher Paul Grice has noted, people
generally abide by the “cooperativeness principle.” The alternative would be untenable
(and indeed, might be technically considered a mental disorder, paranoia): constantly
trying to anticipate ways a person might be taking advantage. People simply do not
expect that others might always be taking advantage of them. When people pick out an
electronic item at a store and are presented with a box purportedly containing the item,
most probably do not open the box and inspect the item. Most shoppers trust the store,
particularly if it has a good name and even more so if it has a prestigious name. Most
people, for example, would probably say that they trust Saks Fifth Avenue. In our view,
any plausible account of trustworthiness assumes a baseline level of considerable
cooperativeness. The neoclassical paradigm’s normative stance, emphasized in the
finance literature and business school education, pushes some people who pay attention
to it – in particular, for our purposes, Wall Street bankers- below that baseline. Thus,
some investors who recently bought products from Goldman Sachs without looking very
carefully at what was “inside the box” were surprised with what they bought. The same
20
people who still trust Sacks Fifth Avenue now might not trust Goldman Sachs. This is
not the way it has always been in New York.
Another part of the story is a psychological “mistake” by many bankers and investors –
underassessment of risk. This is yet another factor that McKay, Keynes and other
economists of an earlier era recognized in their work on the “madness of crowds” and
market bubbles. Only comparatively recently, in the last 15 years, has mainstream
economic analysis again allowed for “behavioral” factors that might complicate the
“rational actor” analysis. But psychologists, including those in marketing departments,
and of course people working in banking and other fields, have always had far more
realistic views as to the bad decisions investors can make. Bankers were themselves
irrational at times. They also, however, had enough insight into other investors’
irrationalities to take advantage of them, a point well illustrated by the enormous profits
that some investment banks and hedge funds made in the housing bubble.
Why Constraints are Needed and Why They Failed
We begin with the self-interest story, the self-fulfilling prophecy of late twentieth century
economics.
The canonical preferences under the “neoclassical” paradigm are money, power, and
status. Money, however, is the predominant factor; pursuit of money in investment
banking yields power and status, and without money, a banker is hard-pressed to have
either power or status. Indeed, more generally power is increasingly up for sale (public
companies are bought in a fluid “market for corporate control” and public servants are
influenced by campaign contributions). Status also is derived principally from money.
Inherited family status is not as important as it may have once been and relatively few
professions in the United States -- perhaps sports, entertainment, and politics -- are
widely recognized for status by itself, apart from money. Democratic ideals also
reinforce the notion that anybody should have the opportunity to succeed; old money is
not needed for power and status. Socially and economically influential wealth can be
recently acquired, indeed so recently acquired that its owner has never experienced a
major economic downturn.
Unless economic incentives such as personal liability rules are aligned to encourage
responsible behavior, bankers can acquire money and with it, power and status, by
behaving in an irresponsible way – taking on reckless risk, and engaging in deceitful
conduct. They help themselves to money, power and status, and may or may not also
help their banks and their clients to the same. . But they may also harm others.
Sometimes the people harmed are people the bankers deal with, such as their employers
or their clients; sometimes it is people who agree to have a stake in the bank’s activities
or well-being, such as stockholders or creditors. And sometimes it is third parties, such
as homeowners and taxpayers.
That people can behave in a manner that furthers their self-interest while doing damage to
others is well known; indeed, the characterization of self-interest as rational can be seen
21
as implicitly embedding a characterization of concern for others at one’s own expense as
“irrational.”). Thus, society has designed extra-legal and legal constraints against such
behavior. Familiar constraints include fostering concern for long-term reputation, and of
course legal regulation and liability.
Why aren’t these constraints sufficient to stop reckless banker behavior? Why isn’t law
an effective constraint? Why aren’t reputational concerns and other norms in the industry
an effective constraint? Why has this problem gotten worse over the past few decades,
indeed so bad that three of the top five investment banks in the United States took so
many risks that they failed in 2008? In short, why can investment bankers get away with
so much behavior that does so much harm?
Part of the reason is the way banks are organized. Banks used to be partnerships; the
bankers were the partners. The partner/bankers did not get “salaries” and “bonuses,” as
they were owners and employers, not employees. They were paid a partnership draw out
of some of their banks’ earnings, but the banks retained significant amounts in partners’
capital accounts and used this money to run their businesses. Once a banker became a
partner, he tended to stay at the same bank for his entire career and left most of his
earnings in the bank, only slowly withdrawing partnership capital after he retired.
Perhaps most important, partners were jointly and severally liable for the debts of their
firms. If the bank failed, they paid.
Now, investment banks are corporations. Bankers still get paid largely based on their
bank’s results in the past year and their own apparent contribution to those results;
bankers’ fixed salaries are modest compared with enormous bonuses equal to
approximately one-half of what their banks earn. Unlike the partnership arrangement,
publicly-held banks are not dependent on their bankers’ equity to operate; most earnings
are paid out immediately in cash, stock, stock options, phantom stock and other
arrangements. Bankers usually have substantial discretion about how long to keep noncash compensation in the bank and when to take it out. Because bankers’ compensation
is often linked to reported earnings, there is an incentive for bankers to seek out
transactions that yield huge “earnings” on “paper” that may never translate into actual
currency. The actual wealth of the bank – and the soundness of its financial position –
may be largely irrelevant to the bankers’ compensation, at least in the short term. They
don’t own the bank, somebody else does, and the actually wealth of the bank and its
stability are that somebody else’s problem. When banks lose money bonuses may be
small or nonexistent for a year or two but bankers do not have to give back their earnings
from previous years; they only lose whatever unhedged exposure they have to the banks’
stock price. With the corporate form also comes limited liability; bankers are not
personally liable if their banks fail.
Moreover, bankers nowadays are quite mobile, caring much more about the short term
than the long term. (In any event, computing the long term results of bankers’ efforts can
be quite hard: what is the relevant time horizon over which to measure performance?)
Banks are apparently hard-pressed to make their employees care more about the long
term. And they don’t seem to look for “long-term” results from the employees they hire
22
either. The consequently short time horizons make a big difference. From a short term
perspective, there is good reason to choose a risky portfolio that yields 10% more than a
conservative portfolio, even if there is a 10% greater chance in any given year that the
risky portfolio will lose all of its value, provided one gets a portion of the upside but does
not have to suffer the downside. The shorter the relevant time horizon (the time the
banker expects to be at the bank and exposed to its earnings) the more attractive the risky
investment will be. Stock and stock options can help align the banker’s incentive with
the interests of the bank, but this only goes so far (and basic portfolio theory
demonstrates that option holders prefer more risk than stockholders, while stockholders
prefer more risk than debtholders). If the bankers’ annual compensation is tied to the
upside, but at worst goes to zero because of the downside, the compensation incentive is
all in the direction of taking risk. The banker needs to have an enormous wealth
exposure to the bank itself for the banker’s personal wealth incentive to outweigh his
annual compensation incentive so the bankers’ interests are more in alignment with the
banks’ shareholders (and even then the bankers’ interests are not in alignment with the
banks’ creditors).
That some of the money banks use to make investments is not even that of the bank’s
shareholders, much less the bankers’ themselves, that sometimes it is creditors’ money
and sometimes it is the money of third parties, and that banks that take a share of the
successful investments and walk away from the bad, is not new. Louis Brandeis’s aptly
named book Other People’s Money and How the Bankers Use It was published in 1914.
In the book, Brandeis argued that bankers used other people’s money- specifically,
customers’ money—to promote their own and their banks’ interests, not the customers’
interests. But bankers’ use of others’ money is now carried out on a much greater scale,
in more complicated transactions, and by bankers that are far less likely to have a
personal relationship with the people whose money is being used.
The amounts of banker compensation are so large that many bankers can retire quite
young and never need to work again. The amounts are also so large that increasing
increments may be valued more as “points” that give status than as aids to a better
standard of living. The status might be outer-directed; bankers may ‘compete’ for who
has the largest pay package or income. It also might be inner directed: a person may
think more of herself for making $2x than for making $x. Causing the bank to lose
money is a secondary concern. Exposing a bank’s creditors to losses is not a concern at
all, because this is precisely what economic theory tells us wealth-maximizing borrowers
will do to the maximum extent they are permitted to do so. The banker who does not get
this point is not fit to compete.
Bankers may also get status by taking big risky bets or coming up with a “creative”
technique that helps a client improve its financial appearance. There are considerable
monetary and status rewards for inventing or investing in the hot new thing or of
developing a scheme that allows a company to minimize its supposed liabilities by
labeling debt as something else. This type of gamesmanship has always existed in
finance, but the pace has accelerated. Because bankers are now highly mobile, they may
seek to build up personal reputations that highlight their personal skills and triumphs;
23
doing so may involve them acting more for themselves than as part of a team. The
‘triumphs’ at issue have come to include those that evidence sharp dealing: it may be
easier to demonstrate the successful results of sharp dealing – big profits, one-sided
transaction terms- than to demonstrate the successful results of a more cooperative
approach.
The sociology of investment banking has also changed. The modern investment banking
industry is “meritocratic” rather than socially exclusive and global rather than local.
Whereas repeat dealings among those in the industry used to be both professional and
personal, they are now much more likely to be focused on the professional. Whereas the
reputation that was desired before might be a generally “good” reputation in a community
that was geographically defined and heavily reliant on notions of social “class,” now it
may be more narrowly focused on the banker’s individual reputation for professional
success among other investment bankers and other financiers. The group of persons
whose opinion counts is broader than it used to be geographically and in terms of social
background, but also narrower, in that this group now consists principally of other
investment bankers. The broader society outside the world of investment banking does
not count, or does not count for much. Even the customer base for investment banks is
more fluid, as banks compete against each other for the same customers, often on the
basis of price. Having a reputation with customers for delivering honest high quality
services may not mean what it once did. The now not-uncommon narrative for successful
bankers, of pointing to their modest origins (as does Goldman Sachs’s Lloyd Blankfein),
depicting and perhaps envisioning themselves as heroically overcoming the advantages of
persons more privileged than they, also may provide more self- justification for bad
behavior, whether it be dishonesty, lack of concern or others or refusal to accept the
consequences of one’s actions.
Until relatively recently, bankers were selected based on “social” criteria that they
believed served as proxies for trustworthiness, reliability, prudence and other
characteristics; it is not entirely coincidental, though, that some of these same factors
served as proxies for belonging to favored rather than disfavored socio-economic, ethnic
or religious groups . People who appeared to exhibit these characteristics were more
likely to rise to the top than those who didn’t. Some of the proxies chosen in an earlier
time for “social” connectedness such as a Social Register listing for Protestant firms or
membership in a respected synagogue for some of the Jewish firms – were weak proxies
for socially beneficial conduct. Some of these proxies were downright discriminatory,
and illegal to the extent they relied on race, religion or ethnicity. There was, however, at
least an attempt to think about how an investment banker would interact with the people
with whom his firm did business and about his overall reputation within a defined group.
Clearly, this was far from ideal. But moving away from ‘softer,’ less quantifiable
“social” criteria for hiring and evaluating investment bankers means more reliance on
harder, more quantifiable criteria. More quantifiable criteria may be easier for individual
bankers to manipulate. And they also may be irrelevant or even contrary to the long-term
prosperity of an investment bank. The emphasis on quantifiable criteria for defining
merit means yet more emphasis in banking on the one thing bankers believe they can
count -- money. Whether the merit – or even the money – is real is another matter. In a
24
world where rankings rule, individual bankers and their banks will do what they can to
excel in whatever criteria the rankings use, and sometimes manipulate those criteria.
Indeed, the shift to more quantifiable measures is a broader one within society; its effects
are complicated, and certainly not unambiguously positive.
Thus, the rewards for less quantifiable reputation lessen and the rewards for the more
quantifiable points-based reputation increase. Points-based reputation is importantly
“self centered”—a person earns points through his individual participation in lucrative
business areas, such as the sale of new financial products. The executive who can score
big in this year’s markets will be the most prized, regardless of whether the persons with
whom he does business feel they were shortchanged or misled. And if he scores much
worse than his peers, his prospects will plummet, an outcome he can prevent by copying
his peers’ investing strategies even if those strategies are quite risky. Having a reputation
for caution, honesty and caring about the persons with whom one does business does not
easily translate into a point system unless that reputation generates increased business
from customers with whom the banker has a longstanding relationship. For most
investment banks these customers are not as important as they once were (and neither is
the underwriting business that these customers used to bring to an investment bank on a
repeat basis). Moreover, that the sums at issue are so huge can be de-sensitizing. The
traditional adage “one death is a tragedy, a million is a statistic” captures the way some
bankers may think about their work.
A critical development underlying these changes is discussed above: that banks changed
from partnerships to corporations. A corporation can lose other people’s money: if its
debts exceed its assets, the creditors are stuck with the loss. By contrast, in a general
partnership such as the old Goldman Sachs, Lehman Brothers or Morgan Stanley,
partners are liable to the partnership’s creditors if the partnership can’t pay its debts. The
bankers were partners; their personal assets were potentially available to the partnership’s
creditors. Partners thought long and hard before taking big risks; moreover, even if they
were otherwise inclined, partnerships had governance structures that effectively restricted
individual partners’ ability to ‘bet the store’ or otherwise expose the partnership (and
hence the other partners) to considerable liability. Each partner had a stake in making
sure the others didn’t risk his house. Commercial banking was conducted in
corporations, but a mechanism somewhat akin to unlimited personal liability was
sometimes used: assessable stock. Assessable stock obligated the holder to supply
additional capital upon a call by the board of directors if the bank were threatened with
insolvency. Assessable stock was not infrequently used in commercial banks starting in
the late 19th century, and until the 1930s. After that time, it fell out of favor; it also was
no longer as necessary to protect depositors because federal deposit insurance and federal
regulation of safety and soundness took over. 6
In the 1980s, the New York Stock Exchange, of which many investment banks were
members, changed its rules to allow member firms to be publicly held and many
6
The regulatory scheme for investment banks was much weaker, but as pointed out in the text, many
investment banks were general partnerships up through the 1980s, and hence were “regulated” privately,
because partners were personally liable for their banks’ debts.
25
investment banks became corporations. Even the investment banks that remained
partnerships the longest, such as Goldman Sachs, conducted much of their business
through LLCs, LLPs and other limited liability entities. Finally, the law firms that
advise bankers have even themselves switched to being LLCs and LLPs. A norm of
limited liability has firmly taken hold. Investment bankers and their advisors do not have
to pay for the risks they take or the liabilities to which they may expose their firms; the
shield of limited liability has insulated them from the consequences of their actions.
Limited liability has narrowed the perspective of bankers on their own personal
responsibility. “I am not by broker’s keeper” has become the dominant theme in the
industry. A banker’s only partner in this venture is himself.
Limited liability helps explain why bankers don’t seem to fear massive losses as much as
they once did. But why isn’t legal liability more of a constraint? One reason is that some
of the conduct at issue is very hard for law to address, much less police. Another is that
regulators are outmatched in resources, and regulated parties have enormous incentive
and ability to design financial products precisely so they can fall within regulatory cracks,
with regulators unable to catch up. A third is that investment banking is sufficiently
mobile that firms can and will move their activities to places the regulations can’t reach.
A fourth is that even for conduct the law can address and police, liability may not be
much of a deterrent. Critically, existing regulation does not effectively make individual
investment bankers personally liable for their actions. Even when it technically makes
individuals liable, individuals do not have much to fear. For example, a core feature of
the 1933 Act was section 11, which made underwriters liable for misleading registration
statements for securities they underwrote. This provision remains intact, but the threat of
liability is not nearly as meaningful as it once was and as it needs to be. First, securities
are increasingly sold in private placements exempt from Section 11; some instruments
such as security based swaps have been carved out from the definition of a security
altogether. Second and more directly relevant to the central argument of our book,
Section 11 liability is imposed on underwriter firms, not directly on the investment
bankers who run those firms. As noted above, when the firms were general partnerships,
the banker-partners were personally liable. But when the firms are corporations, Section
11 liability is far less of a deterrent – it is simply another liability the firm can incur,
along with all its other liabilities and debts. The firm might in some way punish the
banker for causing the firm to incur Section 11 liability; the specter of such a punishment
might not strongly motivate the banker, though. In this age of banker mobility, the
banker may not even work for the firm when the lawsuit is filed. Moreover, the conduct
that might trigger liability may also yield a huge payoff for the banker (and the bank);
this would also enter into the banker’s assessment of how to proceed. Finally, any
punishment might be counterbalanced by some of the other rewards we have discussed:
obtaining status for using cutting edge envelope-pushing strategies including taking
aggressive stances on what is to be disclosed in a public offering document.
Psychology of Underestimating Risk
26
The foregoing discussion of incentives for irresponsibility explains how it became in
bankers’ self-interest to take reckless risks, to deceive others and act without regard for
others. But pure self-interest isn’t enough of an explanation. In particular, it can’t
explain why bankers apparently underestimated the risk associated with subprime
securities. They would be hard pressed to successfully pursue their self-interest if they
make mistakes of this type. Indeed, the neoclassical paradigm contemplates that people
generally assess risks correctly. But with subprime securities, many bankers seem to
have underestimated the risk: they lost some of their own money as they were losing
their banks’ money (a key distinction being that the bankers usually kept some of their
own money whereas in some instances such as Lehman Brothers they lost all of their
shareholders’ money and a great deal of the creditors’ money). In hindsight, the risks
seem downright absurd. But even in prospect, the risks were underestimated.
Psychology tells us something about why this occurred.
For a long time psychology has been recognized as a critical factor in economic behavior,
particularly in periods of excessive risk taking that produce speculative bubbles and
ensuing economic collapse. Analysis of cognitive biases and other factors has become
more sophisticated, but the psychological groundings of reckless economic behavior that
has been told almost as often as it has been forgotten. Charles MacKay recognized how
“delusional” thinking characterized economic action in his well known 1841 book
Extraordinary Popular Delusions and the Madness of Crowds. Michael Lewis, the author
of Liar’s Poker and The Big Short, recently included the financial mania portions of
MacKay’s book as one of the six classics of economics along with publications by Adam
Smith, Thomas Malthus, David Ricardo, Thorsten Veblen and John Maynard Keynes.
Now, one hundred and seventy years after MacKay, we have access to a wealth of
psychological studies that give us insights on how delusional thinking plays itself out in
assessment of risk. These psychological insights are critical to an accurate understanding
of the subset of economic actors that is the subject of this book: investment bankers.
One easy and probably accurate part of the story is over-optimism and confirmation bias.
The search for “yield” and the great new instrument that maximizes return yet minimizes
risk is eternal; the U.S. culture, and particularly the culture of Wall Street, believes that
brilliance and effort can solve just about any problem. The title of one of the best books
on the crisis sums up the Wall Street response to the obvious objection: “This Time Is
Different.” Confirmation bias makes it possible to (mis) interpret data in a manner
consistent with one’s working assumptions and theory—until it’s no longer possible.
Other mechanisms are probably at work as well, such as those offered by “prospect
theory” and the related “house money effect.” The simple neoclassical economic
paradigm hypothesizes that people assess risk symmetrically. But people do not do so.
In particular, people might be quite willing to “lose” money they never really regarded as
theirs. In this regard, there is considerable anecdotal evidence that early in their careers,
after their first ‘big paydays,’ some bankers put aside a large quantity of money, enough
to maintain a high standard of living for the rest of their lives, freeing them to regard
anything else they have as surplus.
27
More formally, prospect theory hypothesizes that people have a reference point from
which they compute gains and losses. Many bankers’ reference points might not have
been adjusted upwards by their gains during some significant portions of their careers.
Thus, they might not regard amounts they could “lose” from the wealth they accumulated
from previous pay packages as “losses.” Rather, they might see all amounts above the
amounts they ‘started with’ as gains. In the new “meritocracy” many investment
bankers have not inherited money and started with relatively little; just about everything
they have is a “gain” and remains so until they take it “off the table,” perhaps when they
leave the business. We have no empirical proof that bankers regard their earnings from
banks this way; indeed, the “endowment effect” might suggest otherwise. Experimental
evidence shows that people apparently and instantly become quite attached to objects –
even coffee mugs -- they are given, demanding much more to part with an object they
have been given than they would have paid several minutes before to buy the same
object. We cannot resolve this issue as a matter of theory, but we would note that there is
evidence for our view: the “house money effect” described and demonstrated by Richard
Thaler, a leading behavioral economist. A cavalier attitude toward wealth from this
“house money effect” may trump any “endowment effect” that could cause a banker to
want to keep his fortune. People can experience large or unexpected gains as “house
money,” influencing their willingness to take risky gambles in which they might lose the
money.7
Prospect theory also offers insights on the irresponsible conduct that made matters worse
in 2008, once it became clear that many risks that investment bankers had taken were
unraveling and bankers knew that they and their firms were in trouble. In such “loss
frames” decision makers have been shown to be prone to take exceptionally large risks to
avoid a loss. There are many examples: Nick Leeson’s risky bets that were aimed at
‘recovering” the amounts he had already lost come immediately to mind. As is wellknown, the result was that a bank that had been in existence since 1762 collapsed.
Courses of action that might allow bankers to cut their losses -- for example selling
Lehman Brothers to the several suitors that approached senior management early in 2008
about an acquisition – will be rejected because those options involve acknowledging that
a business plan has in part failed. Reckless risk is seen as a way of escaping the
consequences of reckless risk.
In this way cognitive biases in a loss frame can exacerbate a well known aspect of
irresponsibility discussed in Chapter 1, which is lack of accountability and unwillingness
to accept the consequences of one’s actions. Where someone is “doubling down” to
recoup amounts he has already lost, the chances are also reasonably good that he will
conceal his prior losses and present strategy. Thus, another aspect of irresponsible
conduct identified in Chapter 1, deception. Even if a banker’s risk-taking was
unauthorized, the bank may have an interest in concealing the initial risk and the
subsequent “doubling down.” Government actors may also participate in the deception to
avoid a market upheaval. The “psychology of the cover up” firmly takes hold, at least
until the markets discover what is going on.
7
Being risk-preferring may be helpful in obtaining and excelling in fields like investment banking.
is some evidence that this is the case with CEOs.
There
28
Finally, neuroscience studies suggest that some people are simply more prone to riskseeking behavior – such people may be overrepresented in the ranks of top bankers. Of a
piece with the neuroscience findings are the research findings from the psychology and
management literature about the characteristics of the sort of people who become top
bankers: people who are overoptimistic and assertive.
Summary
In sum, through a confluence of factors, banking now makes possible and rewards
behavior that can have disastrous effects on banks, their clients and stockholders, and the
greater society. The types of people attracted to banking want to be ‘movers and
shakers;’ they hope and expect to earn a great deal of money, and perhaps, retire quite
young. Their community is one that rewards clever and narrowly self-interested
behavior. As we will argue below, it is unlikely that enough can be done either through
regulation or through classic economic techniques such as better alignment of incentives
or better monitoring to counter banker incentive and ability to proceed in the ways we
have seen. Whatever specific efforts we take need to be accompanied by a broader push
to redefine what banking is, and how bankers should want to behave.
But the focus has not been on redefinition. Indeed, because economic analysis has been
so dominant in discussion of how investment bankers behave, it is not surprising that the
“calculated pursuit of self interest” model has been assumed as a given and then used to
design policy solutions; redefinition has been assumed to be if not impossible then not
necessary given its difficulties and the supposedly good-enough alternative from the
standard toolkit of economic incentives. For example, neoclassical economics might lead
us to consider a simple solution to the problem of investment bankers helping clients lie
to third parties: to attack the problem at its root cause, the banker’s calculated pursuit of
self interest, by changing the banker’s calculation of his self-interest. We could try to
make the banker internalize the external costs of fraud, by, for example by imposing civil
liability for aiding and abetting fraud and/or stepping up government enforcement efforts
against bankers who aid and abet fraud. But a fault-based regime premised on aiding
and abetting liability is not likely to be effective by itself. Consider in this regard
bankers helping their clients hide debt; while we think this clearly is fraud in any
common-sense understanding of the term, proving that it constituted fraud so as to prevail
in a legal proceeding might be very difficult. The term “debt” cannot be mechanically
defined; bankers will be able to argue that their clients’ financial statements were
accurate. Companies are certainly not required to depict themselves in the most
unattractive way possible. Even clear rules defining “debt” or any other term can often
be maneuvered around (and probably will be, by well-motivated and very able bankers);
we resist standards because we value predictability, and because enforcement is costly
and may seem arbitrary. In any event, ex post enforcement may be too late to avoid
huge damage. That a bank would figure out a new financial beautification technique,
use it a great deal, and significant damage would be done before it could be stopped
scarcely seems unlikely- indeed, that is what happened with both Enron and Greece.
29
The critical point is that people trying to maximize their money and status in the present
world with its present system of rewards have the incentive and ability to maneuver
around even a good regulatory scheme. A needed part of any solution is therefore to
change the people—to instill a sense of personal responsibility such that they are not
simply trying to maximize their money and with it their power and status. Their sense of
self worth should come from somewhere else.
Chapter 3
The History of Investment Banking, and the Trajectory towards Irresponsible
Banking
This Chapter will discuss the history of several investment banks, emphasizing those
factors affecting the personal responsibility of investment bankers that have changed over
time 8. We will focus particularly on the Salomon Brothers partnership and its
traditionally responsible attitude toward risk, how Salomon became a corporation in the
Phibro merger, and how the culture that Michael Lewis described in Liar’s Poker led to
the firm’s relatively quick demise.
In this Chapter, we will also discuss the LBO wave of the 1980’s, in which companies
were bought for a very small amount of equity and a massive amount of debt. Junk
bonds and other financing vehicles were designed by investment banks to make these
deals possible. Much of this business was done by Drexel Burnham Lambert, a firm that
after several mergers had evolved out of the venerable Philadelphia firm Drexel &
Company, founded by Austrian immigrant Francis Martin Drexel in 1837. When a
bankruptcy wave followed the LBO craze, this one hundred and fifty year old investment
banking firm was among the casualties, along with many of the companies that had been
leveraged in the LBO transactions it had financed. Michael Milken, the mastermind of
these financing schemes, went to jail for insider trading.
This LBO wave was, especially in its later years, driven by investment bankers seeking
short-term gain from excessive risks that caused considerable damage to acquired and
acquiring companies, their employees and the lenders involved. The concept of limited
liability was taken to its limits, as more and more debt was piled onto entities run by
shareholders with a relatively small stake in the enterprise. Contractual control by debt
holders proved inadequate to control excessive risk taking. Whereas the early stages of
the LBO wave involved companies with relatively stable earnings, the latter stage
involved less stable enterprises that never should have incurred so much leverage. The
investment bankers who put these deals together earned big up-front fees from the risks
they were foisting on others. Like the bankers in the 2008 financial crisis, many of these
bankers believed – or at least claimed -- they had created a brave new world in which the
transactions they were doing would pay off for everyone involved notwithstanding the
heroic assumptions required for the debt incurred to be paid off and the leveraged
8
Other factors that we believe to be more constant such as psychological biases are discussed in other
chapters.
30
companies to avoid default. This mindset appears to have been yet another product of the
pathologies we discussed in the context of the 2008 crisis: declining marginal utility of
money for investment bankers who become oblivious to risking even their own assets
much less the assets of other people, insulation of investment bankers from real downside
risk that they would have had in the days of general partnerships and investment bankers’
desire to keep up with their peers in pursuing the latest financial trends.
The chapter will conclude with a brief discussion of what happened at several other
firms, including Bear Stearns, Morgan Stanley, Lehman Brothers and Goldman Sachs,
comparing these firms to Salomon Brothers. In this regard, consider that Morgan Stanley
– the investment bank most readily associated with a white protestant upper class in the
early and middle Twentieth Century– had a credo to “do first class business in a first
class way.” After going public, a less than successful merger with Dean Witter, and a
series of scandals, much has changed at Morgan, although some Morgan bankers still
think of themselves as better bankers than their peers. The Lehman Brothers discussion
will focus on the firm’s culture in the days when Robert Lehman was the managing
partner and the very different culture that prevailed when shortly before its failure
Lehman concealed from just about everyone – including apparently the risk committee of
its board of directors -- how leveraged it really was. Goldman, the last of the Wall Street
partnerships to go public, is still an enormous profit center for its bankers and sometimes
for its shareholders. With two Secretaries of the Treasury in fifteen years and several
more high ranking officials in the Treasury Department and elsewhere, Goldman also
seems to have mastered the revolving door between Wall Street and a government that is
supposed to regulate Wall Street. Goldman also has had its share of scandal, including a
fraud claim by the SEC that settled in 2010 for $ 550 million, an enormous sum that still
only constituted 15% of its first quarter profit.9 Goldman’s most senior bankers still
refer to themselves as partners (they take away a substantial share of the firm’s profits
when it does well), although they are not.
Chapter 4: The Limits of Limited Liability
This chapter will discuss the broader debate in corporate law on limited liability and
whether it undermines personal responsibility.
In a seminal case used in corporate law classes, Walkovszky v. Carlton, Walkovszky was
injured by a taxicab. The cab was operated by a corporation; the controlling owner of the
corporation was William Carlton. Walkovszky’s damages were greater than the
corporation’s assets. He sued Carlton individually, and lost. The law provides that
corporations have a liability “shield:” owners are not liable for their corporation’s debts.
The result is that Walkovszky was not compensated for his loss, and Carlton kept his
assets. The corporation’s liability was “unlimited” – that is, any and all of its assets were
available to pay its creditors. But Carlton’s liability wasn’t: he could suffer some losses
insofar as the corporation he owned had to pay out funds, but he kept whatever he had
9
Goldman Settlement: Who Wins, Goldman or SEC?, WSJ Deal Journal Blogs, July 15, 2010, at
http://blogs.wsj.com/deals/2010/07/15/goldman-settlement-who-wins-goldman-or-sec/
31
outside the corporation. It should be noted, too, that Carlton was not only the owner of
the corporation that operated the accident-causing taxi; he was also the manager. Being a
manager didn’t make him liable either.
If Carlton had not incorporated his taxicab business, his assets would have been available
to satisfy the business’s debts, including its debts to Walkovzsky. That they were not
reflects a deliberate policy decision under law: to encourage business activity by allowing
people to engage in business without exposing their full assets to the business’s creditors.
This policy decision has always been controversial. Indeed, in the Carlton case itself,
Carlton had ten taxicab corporations, each of which had only 2 taxicabs. The way in
which Carlton did business was clearly designed to reduce the pot of assets available to
each corporation’s creditors. As the case noted, “[t]he law permits the incorporation of a
business for the very purpose of enabling its proprietors to escape personal liability.”
The privilege “had its limits,” but those limits were not reached by Carlton’s way of
doing business.
Even if the taxi business’s drivers and mechanics were chosen for their low wage
demands rather than their skill, and perhaps even if Carlton took all the money from the
business’s cash register each night to assure the business had no money, Walkovzksy
would probably still have not been able to “pierce the corporate veil” to recover from
Carlton’s assets. The doctrine has various formulations in different jurisdictions but
effectively only requires piercing if the corporate entity is disregarded- for instance,
Carlton failed to abide by corporate formalities and commingled the corporation’s money
with his own, paying personal expenses (such as, as occurred in another case, a pet’s
veterinary bills) from the corporate coffers- and if the corporate form is used for
something wrongful or fraudulent. Again, doing business in a manner intended to limit
the amounts available to creditors does not count as something wrongful for this purpose.
If Carlton had thought his personal assets might be available to satisfy his business’s
creditors, he would probably have run his business more carefully. It is hard not to feel
sympathy for Walkovszky, injured by Carlton’s business when Carlton gets to keep his
assets; indeed, many of our corporate law students think Walkovszky should get to
recover from Carlton’s assets. There is something disturbing about Carlton perhaps
scrimping on safety to increase his profits, where the result is losses that he can
externalize onto unfortunate people injured by his business.
This sentiment- that limited liability undermines personal responsibility- has been
common since government began permitting limited liability by allowing “incorporation”
or its historical predecessors. Indeed, originally, entities allowed to have limited liability
had to have specified, and public, purposes – the state was willing to allow limited
liability only to entities doing “good.” And incorporation was certainly not given easily
as a matter of right. But in modern times, an entity’s purpose needn’t be public or even
specified: Delaware corporations’ purposes in their incorporation documents are
routinely set forth as follows: “The purpose of the corporation is to engage in any lawful
act or activity for which corporations may be organized under the General Corporation
32
Law of the State of Delaware.” Obtaining corporate status could scarcely be easier, and
requires only the filing of a few short documents. Sometimes even the limitation to
“lawful activity” in corporate charters is not taken seriously by managers who believe
themselves immune from personal liability regardless of whether the corporation acts
illegally.
Indeed, critics of limited liability have worried about bad consequences of limited
liability for centuries going back to the 1720 collapse of England’s South Sea Company,
a trading company that was essentially run as an investment bank to speculate in
government debt.10 England’s 1720 Bubble Act responded to the collapse of the South
Sea Company, which purported to be a trading company but operated mostly as an
investment bank and promoted widespread speculation in its own stock. The Act sharply
curtailed publicly held limited liability companies for almost a century.11 Next was the
English Companies Act in the late Nineteenth Century, which established the beginnings
of mandatory disclosure to investors. Securities regulations followed in France, Germany
and other European countries in the first decades of the Twentieth Century. In the United
States, the states tried to require some disclosure to investors and regulate fraud with
“blue sky laws” but these could not keep up with interstate commerce and excessive risk
taking in the 1920s caused yet one more economic collapse. The response was massive
regulation in the federal securities laws of the 1930s.
Other doctrines have attempted, with mixed success, to limit the harm limited liability
and its attendant effects on personal responsibility can do. For some companies,
government requires mandatory levels of insurance. Commercial banks and other
depository institutions are supposed to be monitored for safety and soundness. The veilpiercing doctrine mentioned above and related doctrines allow control persons sometimes
to be liable for their corporations’ debts notwithstanding limited liability. For example, a
corporation’s owners may be liable if the corporation engages in an ultra-hazardous
activity. The traditional cases involved blasting and similar activities. One could argue,
however, that some types of investment banking have the potential to be ultra-hazardous
activities as well. Such an argument would justify holding bankers who cause their
institutions to engage in these activities to be personally liable, an idea to which we shall
return in the next Chapter. We explore as well in that Chapter other reasons – including
the large percentage of profits that is paid out in compensation -- for making investment
bankers personally liable for some of their banks’ debts.
Making investment bankers liable for their banks’ debts is not a new idea – in fact,
limited liability is relatively new to the industry. The largest investment banks have for
the most part been operating under limited liability only for the past three decades. They
had been general partnerships; all partners were unlimitedly liable for all of their
10
Richard W. Painter, Ethics and Corruption in Business and Government: Lessons from the South Sea
Bubble and the Bank of the United States, supra note ___.
11
London solicitors did a considerable amount of business helping promoters evade the Act. Richard W.
Painter, Ethics and Corruption in Business and Government: Lessons from the South Sea Bubble and the
Bank of the United States (published by the University of Chicago Law School) (2006 Maurice and Muriel
Fulton Lecture in Legal History), posted on SSRN Minnesota Legal Studies Research Paper 06-32.
33
partnership’s debts. As discussed in Chapter ___, the events of 2008 strongly suggest
that limited liability has not been a successful organizational form for investment
banking, except perhaps for the bankers themselves. It has not been successful for the
rest of the society. We will argue in the next Chapter that for investment banking, a
modified version of limited liability is appropriate.
Chapter 5: Why Law Isn’t Enough
We think bankers should behave in accordance with the standards befitting a profession;
they should do so because it is “the right thing to do.” We also think that society’s
interest in having bankers behave responsibly justifies regulation. Banker behavior can
impose significant negative externalities. However, without attempts through other
methods to instill a sense of responsibility, regulation is likely to be insufficient. This
Chapter explains why this is so.
A simple way to make our point is by analogy with the tax system. Some – perhaps
many -- sophisticated taxpayers and their advisers expend significant resources to pay the
least tax possible, using strategies that adhere to the letter of particular regulations while
violating the spirit. “Well”-advised taxpayers reduce their tax liability considerably;
others are left to pay more to make up for the shortfall. Tax advisers get internal and
external rewards from their cleverness and coming up with the best strategies to avoid
tax. The history of tax regulation is a history of largely failed approaches to this problem.
There are enormous rewards to paying less tax, and prevailing norms do not penalize, and
may even reward, clever ways of achieving this result – of staying one step ahead of the
regulators, and using other “minimal compliance” strategies to make colorable arguments
that justly earn the epithet “legalistic.”12
Tax evasion is a serious social problem, but bankers who stretch the limits of the law
probably do more damage than loophole-seeking taxpayers and their advisers. Taxpayers
are able not to pay tax, which results in lost revenue. The law’s legitimacy also is
compromised, and people are less apt to comply overall, as they see one law for the
privileged few who can afford sophisticated tax advice and investment strategies that
avoid tax and another law for other people who pay the tax. But even a pessimistic
scenario of tax evasion would not contemplate damage of anything like the magnitude we
have seen to society – and to the government’s treasury -- from banker behavior leading
up to the 2008 crisis.
Attempts to regulate bankers are likely to have limited effectiveness for many of the same
reasons that attempts to limit tax evasion and avoidance do. The resources available to
subvert attempts at regulation are enormous: private parties have both the incentive and
ability to “push the envelope” to find the most favorable interpretations and techniques
consistent with facial compliance with law. The norms of the relevant community permit
12
We do not address normative arguments about how much tax people “should” pay; arguably many
people who earn a lot use these strategies to pay less than their “fair share.”; even if however some of these
taxpayers still pay more than their “fair share”, one wonders about the ethical integrity of a system where
the answer to excessive taxation is tax evasion.
34
and even encourage this behavior. Many of the people “hurt” are third parties in no
position to constrain the behavior; they “should” be represented by government, but
government is not up to the task. We develop the story in more detail below.
One reason law is not more effective in constraining banker behavior is that regulators
have difficulty keeping up with new financial instruments, new technologies and other
developments. The explosive growth in the market for derivative securities, swap
agreements, and collateralized debt obligations in the last twenty years illustrates this
point. Investment bankers designed and marketed new financial instruments so rapidly
that regulators could not keep up. Investment bankers may not have understood the
instruments they were investing in, but regulators understood them even less.
Another reason is that regulation is a delayed reaction. Regulators have to decide which
agency shall regulate a financial instrument or practice (there have been notorious turf
battles between the SEC and the CFTC about this). Regulators then must deliberate over
how to regulate something and draft a regulation. The notice and comment period
required by the Administrative Procedures Act adds to the delay before a rule is in place.
By then investment bankers may be selling a new and different financial instrument or be
engaged in a new business practice that is not subject to the regulation.
Third, regulation is a cat and mouse game in which investment bankers hire lawyers to
help them get around regulations. This problem raises concerns about the moral
responsibility of corporate lawyers. As we will explain, lawyers themselves are part of
the reason why law is sometimes an ineffective instrument for regulating business
conduct. Complicating matters, for some cases, there is no one principled answer to the
question of what the regulation should reach.
Fourth, regulators are sometimes captured by regulated industry and do what the industry
wants at the moment, rather than what is best for the industry in the long run. Capture
results in part because of the revolving door of employees between the private sector and
government, particularly at the most senior levels. Government is supposed to regulate
Goldman Sachs and its Wall Street competitors, but to some extent the shots are called by
a group of individuals who work for government and investment banks consecutively.
Hence the phrase that became popular in the media a few years ago, “Government
Sachs”. The revolving door helps regulators understand the industry they regulate but the
revolving door also gives regulated industry more influence over the content of
regulation.
Fifth, regulators also often lack the resources to enforce regulation. The SEC budget is
substantial but it pales in comparison with the budget that investment banks devote to
designing new financial instruments, hiring lawyers to get around regulation, and fighting
SEC enforcement actions. Also, many securities frauds all over the country are
perpetrated by promoters other than large investment banks, and the SEC may devote
scarce enforcement resources toward this low hanging fruit rather than untangle the
complexities of what is going on at Lehman Brothers or Goldman Sachs. Sometimes
35
even low hanging fruit – including warnings the SEC got about Bernie Madoff – is
ignored.
Sixth, regulators have to deal with Congress and financial institutions have influence with
Congress. Congress makes laws that define regulators’ authority. For example, Section
2A of the 1933 Act and a parallel provision in the 1934 Act, as amended in 1999,
removed security based swap agreements from the definition of a security and
specifically prohibited the SEC from promulgating regulations designed to prevent fraud
in these instruments. Congress thus expressly prohibited the SEC from preventing fraud.
The political atmosphere of the 1990s made this effort – led by Senate Banking Chairman
Phil Gramm -- possible. Moreover, regulators’ enforcement of existing law is under
Congressional oversight. Congress puts pressure on regulators on behalf of regulated
companies that also happen to be campaign contributors and political supporters. For
example, former SEC Chairman Arthur Levitt in 2001 wrote a book about his tenure at
the Commission and the pressure from Senator Gramm and others to back off on
regulating the accounting industry. The appendix to Levitt’s book includes letters he
received from Congress and very similarly worded letters he received from Enron CEO
Ken Lay complaining that the SEC was interfering in Enron’s relationship with its
auditor Arthur Anderson. Levitt was expected to listen to Congress and Congress was
listening to Lay.
Seventh, regulation is generally confined to national boundaries. Regulation across
national boundaries, even within a group of countries such as the EU, is difficult.
Worldwide regulation is nearly impossible. Global investment banking, by contrast, is
rapidly expanding. Opportunities for regulatory arbitrage are frequent, as illustrated by
the Lehman Brothers Repo 105 transactions that concealed debt on Lehman’s balance
sheet. When New York lawyers refused to bless a dubious short term sale of Lehman’s
bad assets to get them off its balance sheet for a few days at the end of the quarter, the
deal was done in London and blessed by English solicitors who reported it as a legitimate
transaction to Lehman’s accountants in New York. Another example is the assistance
that Goldman Sachs and other New York banks gave to Greece in using derivative
securities to conceal government debt from the EU and from Greece’s creditors,
precipitating a second financial crisis in Europe. Finally, the United States Supreme
Court this past summer recognized that United States securities laws only go so far. The
Exchange Act’s antifraud provisions, the Court said in Morrison v. National Australia
Bank, do not apply to securities transactions that take place outside of the United States.
The United States is not, and cannot effectively be, the world’s policeman against
securities fraud. While there is hope for more global cooperation than at present,
worldwide government regulation of securities transactions will be very difficult.
The foregoing is mostly focused on federal regulation. State regulation might in theory
be possible as well. But where the regulation is similar to the federal regulation, the same
objections as are set forth above should apply. Another state body of law, corporate
fiduciary duty law, isn’t likely to help either. Corporate directors -with the shareholder
consent that is almost always forthcoming- can choose the state where they incorporate
(or reincorporate) and perhaps for this reason, the law is very deferential to corporate
36
officers and directors. Corporate law also focuses on process rather than substance,
making it easy for corporate managers with good legal advice to comply. Absent
evidence of self-dealing of the sort the law recognizes - an officer selling the company
headquarters to himself, for instance - or a failure to act in the face of a known duty to act
courts will not find directors to have breached their duty. For example, when
shareholders sued Citigroup’s directors for failing to exercise their oversight duties in
permitting Citigroup to invest in subprime securities, the Delaware Chancery Court
dismissed the suit, noting that “oversight duties under Delaware law are not designed to
subject directors, even expert directors, to personal liability for failure to predict the
future and to properly evaluate business risk.” Excessive risk, like excessive
compensation, is an issue that state courts deciding corporate law cases do not want to
address. The “business judgment rule” gives them an easy out.
In our view, the one legal response that could work is the legal response that has not been
tried since the days of investment banking partnerships -- personal liability for highlycompensated bankers. This is one of the few changes that could make a difference. It
would make a difference because of standard “incentive alignment” –bankers would not
want to behave in a manner that subjected them to the risk of losing not just their stake in
their employers but the risk of losing everything they own. Personal liability could also
make a difference if it created and reinforced a norm of personal responsibility, moving
us away from the ethos made possible by limited liability where bankers are free to
disregard others’ interests and only advance their own. This relatively simple solution,
however, has not been chosen, and the law has instead focused on solutions far more
complex and probably far less effective.
Chapter 6: Restoring personal and professional responsibility to investment
banking
The previous chapter discussed the limits of law, and the need to change the ethos of
bankers and investment banking. How can the ethos be changed? We will discuss in
this chapter in detail a variety of proposals summarized in our introduction above. These
include promoting the growth of regional banks more likely to be tied to the interests of
the communities they serve, encouraging banks to pursue select areas of client service
such as brokerage, underwriting and/or mergers and acquisitions instead of “full service”
banking likely to involve conflicts of interest, discouraging proprietary trading by banks
that creates conflicts of interest with client services and exposes banks to undue risk,
changing hiring and compensation practices at banks, reintroducing some measure of
personal liability for the most highly paid bankers, changing compensation arrangements
to align the incentives of lawyers and other professional representing banks with the long
term interests of those banks, increasing business ethics training and professional training
for investment bankers, developing and promoting best practices for bankers and banks
(including codes of professional responsibility), promoting shareholder activism on this
issue, and generally encouraging public debate on how to counter norms of sharp dealing
in this industry and supplant them with norms of personal and professional responsibility.
37
All of our proposals have as their aim to increase the personal and professional
responsibility of bankers. One proposal involves encouraging regional banks. Bankers
who lead such banks live in the communities affected by their activities – they and their
family members are likely to have leading roles in local charitable organizations, schools,
churches and temples and see first-hand what socially responsible banking – and socially
irresponsible banking – does to people’s lives. Regional bankers have the added
advantage that the portion of the world they learn about through charitable, religious and
social activities is the same as that which is most affected by their banks. It is therefore
important that policy makers consider whether too much financial power is now
concentrated in the hands of multinational institutions headquartered in London, New
York, Tokyo and a few other world financial capitals. People and businesses in
Pittsburgh, Philadelphia, and Minneapolis need financial services, and these services may
be better if they originate in the communities they serve.
Also, from a societal perspective, regional banking is an important means to accomplish
broader objectives. Just as excessive concentration in one investment is inadvisable,
society should not allow large portions of the economy to be exposed to financial risks –
and ethical risks -- concentrated in the decision making of a few individuals in faraway
places. Diversifying the power base in banking, and spreading it out geographically may
help make this sector of the economy conduct itself more responsibly.
Another proposal concerns potential monetary liability for bankers. We describe in this
chapter the broad outlines of various proposals to impose some measure of personal
liability for a bank’s debts on the most highly paid bankers. We would impose strict
liability, up to a certain amount, on highly compensated bankers: bankers would be liable
for their banks’ obligations to creditors if the banks became insolvent, and their liability
would exist regardless of whether they were in any way “at fault.” A proposal that we
will emphasize here and discuss in some detail would revive two mechanisms that
imposed strict personal liability in an earlier era: general partnership, which was
common for investment banks prior to the 1980s, and assessable stock, which was
relatively common in corporations including some commercial banks through the 1930s.
We propose that bankers earning over $3 million per year be required to enter into a
partnership/joint venture agreement with the employing bank that would make them
personally liable for some of the bank’s debts. We also propose that compensation in
excess of $1 million per year be paid to bankers only in stock that is assessable in the
event of the bank’s insolvency in an amount equal to the book value of the stock on the
date of issue.
We believe that imposing genuine downside risk through these or other vehicles for
personal liability is the best way to make bankers approach risk in a manner consistent
with their broader social responsibilities. One reason why we prefer a regime of strict
liability to a negligence regime is that we want bankers to be mindful of the risk their
banks are taking, taking care themselves and monitoring each other. We do not want
them focusing on ways to demonstrate that they were not at fault.13
13
There are other reasons why we think a negligence regime is a bad idea. Negligence is a sufficiently low
bar that uncompensated losses would presumably almost always yield lawsuits. And the standard is
38
We recognize that a law requiring bankers to be personally liable will not be easy to
enact. And even if it were enacted, it would not be a panacea. Without an accompanying
ethos of responsibility, we can expect considerable resources expended at evasion of the
scheme. We also might expect maneuvering to avoid the day of reckoning –
sophisticated ways to challenge whether a bank was really insolvent, for instance. And if
banks approached the zone of insolvency, our proposal might encourage particularly
risky behavior by some risk-loving bankers who thought extreme risk-taking might
succeed in turning things around, or those who simply thought that if they were going to
be personally liable up to a certain amount, they might as well “go out with a bang.”
Again, without an ethos of personal responsibility, our proposal wouldn’t be nearly as
effective.
There is another important limitation. The personal liability in our proposal is liability
for the bank’s debts when the bank is unable to pay. Goldman’s Sachs’s conduct in
helping Greece conceal its debts, and many banks’ conduct in helping Enron conceal its
debts, yielded considerable fee income. Our proposal on its terms does not address that
situation. Personal liability for involvement in fraud might help, but again, such an
approach has significant limitations. Accounting is perhaps necessarily an art rather than
a science. We can’t develop rules as to what counts as a “correct” depiction of a
company; the best we can do is develop some necessarily underinclusive rules as to what
constitute incorrect depictions, together with fairly loose standards that might reference
something like ‘what an investor would find material want to know to make an
investment decision.’ The intractably difficult problems of line-drawing, coupled with
the complexity of the strategies used by bankers and regulators’ inability to keep up, all
combine to make it unlikely that making bankers personally liable for “fraud” will
significantly curtail the behavior we are concerned about. Bankers are able to devise new
techniques that have not been judged to be fraud, and that they can argue are acceptable
given what has been accepted previously. This is the same issue we discussed above in
the context of tax. Indeed, the analogy to tax shelter techniques is a particularly good one,
since the respective techniques both focus on creating desired appearances: tax shelter
techniques often make taxpayers look worse than they are, whereas the accounting
techniques bankers use make their clients look better than they are. But in the absence of
a determinate mapping of a company’s attributes to how it must be depicted for tax or
accounting, a tax adviser or banker has considerable discretion—discretion that will be
used to societally destructive ends in the absence of an ethos of personal responsibility.
Moreover, in this context and more broadly, the more regulation attempts to specify what
is prohibited, the more it may sanction an ethos in which whatever is not prohibited is
permitted, stoking the search for loopholes and further validating the self-interest
permitting norms that have developed. Indeed, while regulation of financial institutions
and markets is a potentially important constraint on irresponsible behavior, if we
sufficiently nebulous and perhaps pervasive that hindsight bias might dictate liability more than legal merit.
In other words, much would be spent on litigation, and the set of lawsuits that succeeded might very well
not be the right set by any normative metric. Significant resources would also be expended documenting
lack of negligence – a full employment act for lawyers of the sort crafted in the famous Van Gorkom case.
39
overemphasize regulation as a means of addressing the problem, we may make matters
worse: legal rules could crowd out the core components of personal responsibility.
This chapter will discuss how a personal liability regime must be coupled with other
measures that reinforce notions of personal responsibility in investment banking.
Education in ethics in business schools and perhaps continuing ethics education for
investment bankers is one approach. Borrowing from corporate governance, and from
the literature on corporate social responsibility, banks could be assessed on how good a
job they do making banks and bankers behave well – in this case, assessing how well
they manage risk, and how well they motivate bankers to pursue truly value-adding
innovations. Lists of “responsible” and “irresponsible” banks could be publicized, in a
manner akin to business journals’ publication of lists of companies with good and bad
corporate governance. Organizations that have become heavily involved in pressuring
corporations to be good citizens vis a vis pollution and other issues, including shareholder
activists, could work to pressure investment banks to be good citizens vis a vis the
equally toxic externalities they can impose on society. The government – an
increasingly important actor in finance, and the single biggest issuer of debt securities –
should make it clear that it will not deal with banks that do not meet the criteria for
personal and professional responsibility discussed in Chapter 1: honesty, concern for
others, accountability and a responsible approach to risk. Public pension funds, unions,
and corporate pension funds should do the same.
The investment banking industry has justly been criticized for its role in the financial
crisis; we conclude that with measures to increase institutional and personal
responsibility, the industry can be a force for societal good. Paul Volcker has been
quoted as saying: “I wish that somebody would give me some shred of neutral evidence
about the relationship between financial innovation recently and the growth of the
economy, just one shred of information[sic].” We think that innovation for its own sakeinnovation that is not good for the society, and may even be catastrophic, as has been the
case with CDO3 and the rest of the toxic brew-is importantly related to the lack of
personal responsibility we discuss. We think that with personal responsibility, bankers
would be less inclined to pursue the latest fashion in financial instruments and more
inclined to look for innovation that created value in the long term. We will discuss
contexts in which societally undesirable behavior has been curbed, and new more
desirable norms have arisen. Our aim is, to use a term coined by Kwame Appiah in his
recent book The Honor Code, a “moral revolution.” Appiah’s book demonstrates that
moral revolutions can and sometimes do happen, and gives some guidance as to how to
bring one about.
The change in ethos we describe may have another important and quite felicitous effect.
Present-day researchers in psychology are re-discovering truths long understood by
philosophers, theologians, and authors of great literature, such as that “money doesn’t
buy happiness.” There is considerable research as to the beneficial effects on happiness
and health of being part of a cohesive social network, of “altruistic” behavior and of
trusting other people and being trusted.
40
Some researchers have attempted to devise a new measure of well-being that would take
these types of benefits into account. For example, Robert Frank discusses the status
arms-race that can arise: the race almost by definition cannot be won. Once people start
competing for more money, more prestige, more “points” in the highly competitive zerosum system of values that has become pervasive in banking, they continue, and need to
work harder simply to stay in the same place relative to their peers.
The 2008 financial crisis has already prompted a reassessment of some values; there is
some evidence that the society overall has become a bit less interested in increasing
levels of wealth accumulation and consumption. We hope it can make possible an even
deeper reassessment, and ultimately, a retreat from the atomistic points-based arms race
so vigorously engaged in by investment bankers.
Conclusion
Investment banking has changed enormously in recent years. Some of these changes
have paralleled other changes in our society – less emphasis on geography, social class
and other similarities between people in defining business relationships, and more
emphasis on meritocracy and on rankings and other objective criteria for defining merit.
There is more emphasis on financial products and less emphasis on people. There is
more emphasis on trading and less on corporate finance and the tight customer
relationships that once came with it. There is fluid movement of bankers as well as
customers from one bank to another. Corporate form, and access to public capital
markets, has replaced partnerships and personal liability for firm debts. And there is even
more emphasis in an already mercurial society on a single criterion for measuring status:
money, or at least the appearance of having money.
We discuss in this book ways in which many of these changes have not been for the
better in investment banking. We recognize, however, that this industry will not go back
to the past. We look to the past where the past demonstrates what works and what does
not work, but the relevant investment banking industry for our inquiry is that of the
future.
Restoring personal and professional responsibility to investment banking will require a
combination of strategies. Some involve legal rules, but legal rules are not enough.
Thus, we also will need different business models for banks, and different personal goals
for bankers. These models and goals cannot be defined or required by the law. Rather,
these might be encouraged as industry best practices or through meaningful dialogue
between bankers and the rest of society about the goals of their profession and how
bankers intend to further those goals. This dialogue should be conducted as much as
possible on an individual level by bankers and not simply by financial institutions that
repeat slogans about customer service and corporate social responsibility (indeed the
emphasis on “corporate” social responsibility instead of the responsibility of individuals
who work for corporations lends itself to a public dialogue that reduces personal
responsibility to an advertising slogan with relatively little truth in advertising at that). .
Decentralizing investment banking and reinvigorating regional banking should help.
41
Restoring some measure of personal liability of highly paid bankers for the debts of their
firms should also help. Lawyers and other professionals who help investment banks
structure and sell new products should also perhaps have some of their compensation tied
to the long-term success of those products. Paying investment bankers less money with
less variation from year to year might help if we believe society would be better off if
people seeking big risks to earn big money should perhaps do something else.
Traditionally, the staid investment banks attracted a different type of person that the oil
exploration business or start up technology firms, and stock market speculators worked
on their own and in smaller firms but not in the prestige investment banks. Perhaps the
allocation of human resources between these different types of businesses in out of line
with what they are supposed to accomplish.
Finally, the evidence we have seen – both anecdotal and empirical – does not suggest that
investment bankers are happy with themselves. Many are rich, but human beings have
known for a long time that money does not buy happiness. We think that investment
banking would be a far more rewarding profession if, while retaining a reasonable
measure of profitability (and solvency), investment banks were to slow down and
concentrate on lines of business where bankers can genuinely believe that they are doing
good in addition to doing well. However a banker views his or her own relationship with
humanity as a whole, or with a higher being, most probably want something more out of
life than money, status and power, To the extent they have these three things, they want
to believe that they are using them for good things. Lloyd Blankfein may have accurately
described the aspirations of many investment bankers when he talked of them doing the
Lord’s work. The problem is too many of them don’t. Changing this fact will be critical
to the personal and professional success of investment bankers and, because investment
banking has enormous influence on our economy, to the success of our society as a
whole.
42