In Federal Reserve Chairman Ben Bernanke’s recent testimony before the Financial Crisis Inquiry Commission, he listed employee compensation among the issues that will have the greatest impact on the future stability of our financial system.
Given that it was somewhere in the middle of his list and part of the larger testimony, this nugget could easily have been missed. I say “nugget” because it gets to the heart of a very important distinction: Banks don’t make loans; people do.
Employees grant or deny loans, the banks themselves don’t. Banks are merely legal entities that cannot make decisions. Thus, employee compensation is every bit as important as, say, bank capital requirements.
It has been repeated many times that if the banks and finance companies that originated the many failed mortgage-backed securities would just have had “skin in the game” or capital at risk, the banking crisis would have been avoided. Observers argue that skin in the game would have led banks to make very different credit decisions.
History shows us that this alone wouldn’t have solved the problem, however. Before widespread securitization, savings and loans as well as banks routinely retained capital at risk, and they still made bad loans – lots of them. Why? Because banks don’t make loans, people do. And people act according to their personal interest, not according to the capital requirements assigned to a bank.
When the employees granting or declining a loan lack skin in the game, they have decidedly different interests than the banks’ depositors, and that is a problem. Sometimes called the agency problem or the principal-agent problem, conflicting motivations arise when the interests of the agent and the principal are misaligned.
That means that if regulators don’t change compensation plans for every employee who wields authority to approve or deny loans, little will change in the way of loan performance. Just ask the savings and loan depositors.
This problem permeates our financial infrastructure and puts the entire system at risk. It occurs between bank managers, as the agents, and their principals, the bank’s capital providers. It occurs between private equity fund managers acting as agents and their principals, the limited partners, usually pension funds and endowments. The agency problem even occurs between the chief investment officers of pension funds, who are acting as agents on behalf of pensioners, and the pensioners themselves.
When interests collide
Consider a pension fund that has lost significant value in its portfolio. In this hypothetical example, the chief investment officer has two choices: He can do nothing and likely lose his job. Alternatively, he can make risky investments that have the potential for high returns and high losses.
If the risky investments make sufficiently high returns, the fund might recoup its losses, saving his job. Conversely, if the risky investments incur significant losses, the chief investment officer only loses his job. I say “only,” because in contrast to the pensioners, he has not lost his life’s savings and likely has many working years remaining. Clearly, his interests are not aligned with those of the pensioners.
Let’s say that a private equity fund manager, for example, gets paid an annual management fee equal to 2% of assets under management. And let’s also say she is required to have a stake in the fund equal to 10% of the assets under management.
The fund manager receives the equivalent of her 10% investment through asset management fees in only five years. Given the lengthy gestation period for private equity investments, that means the private equity fund manager will likely recoup her 10% before the results of her investments are known. Again, interests are not aligned.
During periods of asset value appreciation, capital providers worry less about the return of capital and more about return on capital, increasing their tolerance for investment risks. As a result, loan-to-value ratios increase, amortization periods lengthen, and principals require less at-risk capital or skin from their agents. Unfortunately in the case of banks, when those decisions lead to losses, the banks may get the blame, but we the taxpayers get the bill.
A material part of the solution to the stability of our financial system can found at the human level. Bank employees, not the bank, granted the loans that eventually became the mortgage-backed securities that went bad. That wasn’t because the bank employees were bad or incompetent, but because compensation systems for top management and employees rewarded loan volume and relegated loan performance to irrelevance.
Remember, pay, not what you say, drives human behavior.
Chris Macke is principal of Chicago-based General Equity Real Estate, which specializes in hotel and office financing as well as structuring and purchasing sale-leasebacks. He can be reached at email@example.com.