Bankslaughter, Tort Law, and Optimal Deterrence

Felix Salmon has been helping popularize Paul Collier’s idea of bankslaughter. (No, it’s not what you wish it were.) The idea is that there would be a crime called bankslaughter, or “managing a bank irresponsibly.” If a bank blows up, there could be a criminal investigation to determine if the bank managers behaved recklessly (more on that term later); if so, they would be convicted. The analogy is to manslaughter, which is actually a family of crimes; Collier probably means criminally negligent homicide, or causing death through negligent or reckless (more on those terms later) behavior.

Not surprisingly, the conservatives are not happy about this, even though it seems to conform to the conservative principle that people should bear responsibility for the consequences of their actions. (Or maybe that only applies if you are a pregnant teenager.) Salmon cites John Carney, who calls bankslaughter “the worst idea of the week.”

Here are some of his objections:

Collier doesn’t seem to have given much thought to the costs of over-deterrence. Bank executives faced with the prospect of a criminal investigation and possible conviction would likely be overly cautious. We’d lose a lot of socially beneficially risk taking by criminalizing bank failure.

There’s also a serious fairness issue. Only those executives whose risky bets blow up get investigated, prosecuted and punished. Those whose bets pay off are untouched. This means that being unlucky in the markets becomes a criminal matter.  Criminality becomes a kind of lottery. . . .

Because bankslaughter is backward looking but conducting business is forward looking, it would almost certainly result in wrongful convictions. Lots of activity that looks reckless after the fact can seem perfectly sensible ahead of time. Unless the crime required bankers to know they were being reckless—in which case it would deter almost no-one and result in approximately zero convictions—it would wind up punishing bankers for just being wrong.

Regular readers can guess what I think of the idea of “over-deterrence.” We need some more over-deterrence. People can talk all they want about “socially beneficial risk taking,” but the evidence that this happened during the last thirty years is pretty contestable. For a system to have the optimal amount of risk taking, it is necessary (but not necessarily sufficient) that the people who stand to benefit from the venture internalize the risk of failure in some way; as everyone on the Internet has written multiple times, that condition did not hold for the financial sector in all sorts of ways.

But the more interesting argument is whether there is a problem with retroactively holding people liable for harm that they cause unintentionally. Carney writes as if this is just a crazy idea: first, only the people who actually cause harm are prosecuted, as opposed to others who behave equally egregiously but are lucky enough not to cause harm;  second, it allows juries to evaluate behavior in the past with the benefit of hindsight.

What he doesn’t say is that this is exactly how a huge chunk of our legal system works today. It’s called torts, and even though I’ve only had one year of law school, and that was at Yale, where the joke is that you don’t actually learn any law, I know something about it. The general principle is that in most spheres of life, if you act negligently – defined to mean that you do not exercise the same degree of care a reasonable person would under the circumstances – and your action causes injury to someone else (to whom you owe a duty of care), you are liable for that injury. In some areas, the threshold is lower; for example, in product liability, the rule of strict liability applies, which means that you don’t even need to be negligent; if your product hurts someone, you’re liable. In other areas, the threshold is higher, and the requirement is not just negligence, but gross negligence, or willful wanton recklessness, or something like that. But that’s the basic principle; you don’t need intent, and the legal system certainly does assign liability after the fact.

So, for example, if you take a turn too fast on a wet road and you hit someone, you’re liable; but the twenty drivers ahead of you who all took the same turn too fast aren’t liable for anything. And juries decide whether you were being negligent with the benefit of hindsight; they know that the baby stroller was in the intersection, which you had no reason to know when you took the turn (and was highly unlikely, since it was late at night and raining). That’s just the way the law works.

Ironically enough, the modern tort system is a product of the second industrial revolution of the late nineteenth century, and was designed to cater to the needs of large businesses. By creating an objective, supposedly predictable and stable standard of negligence, it made it easier for businesses to manage the risks of their operations. And while there are certainly things they criticize, tort law is one of the main areas where the law-and-economics crowd has won out, and real judges actually talk about things like “cheapest cost avoiders.” For many scholars and jurists, the standard of reasonable care is defined as the degree of care such that the marginal benefit of accident avoidance equals the marginal cost of care; you can see how, in a tautological way, this creates a Panglossian “best of all possible worlds,” since it yields the perfect degree of deterrence. And the reason most economist types (and free marketers) like this way of thinking about tort law is that the whole point of the law is to create the right incentives without the need for all sorts of detailed regulation.

So Carney’s idea that this type of liability would produce over-deterrence is a bit curious. To get optimal deterrence in the bank-management context, you want managers to take precautions (e.g., maintain capital reserves) up to the point where the marginal reduction in the risk of a collapse is balanced by the marginal cost of those precautions. Today, we have no such thing, since we have no meaningful risk of collapse for bank managers, since their downside (relative to their upside) is limited by (a) leverage, (b) the implicit government guarantee, (c) the bonuses they got in the good years, and (d) the “resume put.”  Because there is no liability for blowing up a bank, our legal system provides no deterrence whatsoever, which is one reason why we need regulation. (In a perfect law-and-economics world, you wouldn’t need regulators, since the threat of liability would create optimal behavior all by itself.)

Now, I don’t think that Collier has all the details right. First, I think that criminal prosecution for mere negligence is overkill; civil liability would be plenty, since that way you could go after all of the negligent manager’s assets, including his bonuses from the good years. We could save criminal prosecutions for people who commit actual fraud. Second, Collier uses “recklessness” and “reasonableness” as perfect opposites, which, from a legal standpoint, they’re not; you can fail to behave as a reasonable person would (that’s negligence) without your conduct rising to the level of recklessness.

The thing standing in the way of a civil version of bankslaughter is the business judgment rule, which basically says that if you are a manager who makes an informed decision in a situation where you do not have a conflict of interest, you are not liable, period, no matter how risky or stupid that decision is. And as far as I know, no court has ever held that having a bonus tied to your company’s stock price, with no commensurate downside risk, counts as a conflict of interest (even though it is). The point of the business judgment rule was to enable managers to take risks without fear of liability (or to enable rich people to sit on boards of directors and become even richer doing very little work without fear of liability). But in an environment where it’s very clear that managers were taking too many risks, because there was no way they would suffer the potential consequences of those risks, one very logical and sensible solution is to turn the dial partially back the other way and increase liability, which I see as Collier’s basic point. Since the business judgment rule is basically common law, it could be pared back by statute, and it could be pared back selectively – for example, for businesses whose blowups can have large societal costs.

One weakness of the Obama Administrations financial regulation proposal is that it doesn’t increase real costs for the key actors – bank managers and directors. Instead, it relies on better regulation enforced by better regulators. A civil version of bankslaughter could help fix this problem.

By James Kwak

44 responses to “Bankslaughter, Tort Law, and Optimal Deterrence

  1. Pingback: Friends of Dave (friendsofdave) 's status on Thursday, 09-Jul-09 03:37:12 UTC - Identi.ca

  2. Carson Gross

    James,

    I don’t think “the conservatives” have a unified view on banks. Bear in mind that the largest group of anti-bank bailout agitation came from the *right* harassing the house into rejecting the initial bailout. I think a more useful distinction in this debate is “The New York/Washington Consensus” vs. “The Rest.”

    My biggest problem with the idea? The name.

    Also, it seems like just restricting leverage limits of banks and all financial companies exceeding a certain size to sane levels would be extremely simple and go a long way in solving the underlying problems.

    Cheers,
    Carson

  3. I agree that when it came to generous bank bailouts, a lot of the opposition came from traditional free-market conservatives, who believe that companies run by incompetent people should go bankrupt.

    But when it comes to increasing regulation on financial institutions, I think the battle lines are divided on more traditional grounds.

    This was a weird post because I don’t actually think that just tweaking liability standards on its own is a great solution. But I also don’t think it’s a silly idea.

  4. Criminal prosecution for white collar crimes is basically what you’re talking about James. It’s one of those ideas that gets tossed around for years and years and NEVER comes to fruition. It’s a great idea long over-due. I doubt forceable reaming by bank pen is a crime in the eyes of certain people. Certain…. important lawmakers from say Ohio or say maybe Kentucky…….. 4 words James: IT WILL NEVER HAPPEN.

  5. It certainly isn’t a silly idea. I like it. I like the idea of civil liability. It seems to me that if your organization is backed by the FDIC, it should fall under these laws. Furthermore, if your organization gets overly large–where it can threaten the national economy if it fails–then it should fall under these laws. There’s nothing wrong with legislating that bankers take responsibility for their actions, like the rest of us.

  6. Nice discussion. I suspect that cartel behavior and the consumption of competitors to produce fewer and bigger institutions seems to be an important part of the mass insolvency. Second point, they all engaged in fraud. They knew the sub-prime mortgages were not AAA. They sold them to customers who had less knowledge of the product than they did and they withheld knowledge that would of driven away the customer, hence they are criminally liable, like Enron Execs.

  7. This falls under adding more legislature that won’t be enforced. ie take Mary just now stepping down from SEC, give me a break, stepping down? she should have been fired, fined, civil suit or something, as seems there was a conspiracy going on w/banksters to look the other way, and I will CRAP if she gets a job on Wall Street, which would be par for course. There are so many regs now that most all dept’s can’t even keep up w/security laws, mortgage fraud, lobbyists’ influence, campaign interests, comp trading manipulation, Treas/Fed bailouts that cause morale hazard, rewarding the wrong things, and AIG bonuses of $280M/yr by someone retired on a priv island somewhere now, derivatives getting paid off by failed companies, and on and on. You guys are smart enough to add to this list. They don’t or won’t listen to the smart guys like you. Policies are rushed thru without even enough time to read and understand the ramifications or alternatives available. We are still in such a crisis and I don’t see how the judicial system, if it’s not corrupt too, will even have the ability for due process. The fines are a joke, and seems it certainly pays well to be a criminal now a days. Only the common man is the loser here. As Ted states IT WILL NEVER HAPPEN, BUT WE CAN HOPE FOR CHANGE, HA! If we don’t straighten up the govt from the inside FIRST, prosecute and clean house, we will never have hope of catching the outside criminals.

  8. Not surprisingly, the conservatives are not happy about this, even though it seems to conform to the conservative principle that people should bear responsibility for the consequences of their actions.

    By now we know clearly that for so-called conservatives, this “responsiblity” applies only to non-rich individuals, and only to human activities.

    It never applies to any profit-seeking activity, and doesn’t apply to anything the rich do at all.

    And the reason most economist types (and free marketers) like this way of thinking about tort law is that the whole point of the law is to create the right incentives without the need for all sorts of detailed regulation.

    So Carney’s idea that this type of liability would produce over-deterrence is a bit curious.

    However it may have been in the 19th century, today’s “free marketers” (meaning those who want markets heavily rigged in favor of big corporations) want neither tort law (ergo “tort reform” as a right wing shibboleth) nor detailed regulation. They simply want a free-fire zone. Some of them are even honest enough to call themselves anarcho-capitalists.

    For them any level of deterrence here is over-deterrence.

    No one’s ever going to get anywhere arguing with them or trying to “compromise” with them.

  9. I read the word as “Bank’s Laughter” which is what we have now.

    Isn’t English spelling great?

  10. Could this idea be married to the concept of having a corporate charter revoked in the event that the company acts illegally? The erstwhile shareholders could then argue amongst themselves whose fault it was.

  11. Russ- I guess I’m what is called a conservative, and from my point of view, many in the financial services industry committed fraud.

    However, it does not seem that we need a bankslaughter law. There already are appropriate laws to deal with the situation; they just need to be enforced. That being said it does seem that we need to go back to Glass Steagall, the proper banking reserve requirements, and greater transparency in our regulatory framework.

    Much of the corruption came from the government as well as much of the fraudulent bank behavior was coerced from government officials. It was not a one way street. Huge concentrations of power need to be avoided. The nexus of government regulation and big business, when there are enormous sums of money involved with little transparency of regulation will always end up being a hotbed of corruption.

    BYW, most of those who want the markets rigged in favor of large corporations are either corrupt Rino Republicans or Democrats; get your facts straight. Most free market pundits are even more pissed off than you are about the fraudulent corruption at the crooked casino that is Wall Street. Check out who runs the big investment banks- it’s hard to find a free market Republican among them. Don’t tell me you thought the Goldman Sachs’ guys like Rubin, Paulsen and their acolytes were Republicans, did you? And don’t get me started about the left wing short sellers like Soros, Robertson and Chanos; not to mention the mob run hedge funds associated with Milkin, Icahn and their band of connected lefties.

  12. I absolutely have no idea what the h*ll is going on in this country.

    The financial system ran our economy off a cliff last year – they lent money to people who had no hope of paying back the loan – they made fabulous commissions doing so – they sliced up risky mortgages and packaged them together in tranches that pension funds and retirees and families invested in because they were all triple-A rated investments.

    Middle America lost their retirement funds, their college funds, their savings, their jobs, their employment-related health insurance. The losses have been exceptional – and the pain being felt out there – outside of Wall Street and the Beltway – is extraordinary.

    Bankers got bailed out – got their bonuses (except that AIG guy who quit via the NY Times op-ed page) – and are now seeing “record profits” in 2009 and have the hopes of even bigger bonuses.

    So apparently bankers think that the running the economy of the cliff is “business as usual.”

    Well why wouldn’t they? It’s been a most profitable business model for them.

    If we cannot initiate true reform that prevents the financial community from making ridiculous profits off of the destruction of the economy, then we’re finished as a global powerhouse.

  13. pastafarian

    Anne is exactly right. And we will not initiate true reform until lawmakers are prohibited from taking lobbyist money–not that that’s likely to happen anytime soon. See NPR story today “Need for Campaign Cash Opens Door for Lobbyists” at

    http://www.npr.org/templates/story/story.php?storyId=106396849

  14. James Kwak writes “We need some more over-deterrence”

    Yeah and I guess that if he was a regulator of the insurance companies he would decide to follow the regulatory paradigm concocted by the Basel Committee; and pick three health inspection agencies amigos to rate the health of the insured and require the insurance companies to put up more capital when they sell health insurance to someone with a low health rating and letting them almost off the hook if the insured is deemed to be in tip top form.

    It is so hard for some to grasp that the financial regulations that came out of Basel add up to a crime against common-sense and against the risk-taking the world needs to move forward.

    http://www.subprimeregulations.blogspot.com/

  15. I think you are mixing your criminal law and torts principles inadvisedly. And I would have trouble getting my mind around what is the duty of care (not the standard of care) owed by a banker, and to whom. When it comes to my banking habits, whether as a lender or a borrower I go in the door contemplating an arm’s-length, contractual relationship. I strike that from consideration. Bank management already owes a duty of care to the bank owners, so we can strike that too. What’s left is a duty to prevent collateral damage to unknown persons (society?) from a bank blowup? That brings in the whole foreseeability thing. I guess I’m unpersuaded.

  16. Also, you’ve all probably read Michael Lewis’s take on AIG, but if not, http://www.vanityfair.com/politics/features/2009/08/aig200908
    I’m not sure the chain of causation is as simple or clear as it may seem.

  17. Paul, the facts are as straight and clear as can be. I didn’t distinguish between “Republican” and “Democrat”; there’s practically zero difference. I can’t imagine why anybody would try to distinguish them on economic issues. (Or pretty much any structural issue.)

    Together they constitute a corporatist cabal; on every front there seems little hope for anything other than the further entrenchment of rent-seeking parasites, and the Obama agenda is shaping up to be almost as nightmarish as the Bush agenda. On no significant front is he seeking to do anything but perpetuate Bush.

    The entire power elite is composed of the market racketeers I earlier described. I see no significant exceptions anywhere, in politics or the mainstream media.

    I don’t think the criminals need to worry about being called to account anytime soon, by a “bankslaughter law” or by any other mechanism.

    On the contrary it’s clearly unanimous among the “leaders” that American history’s worst capital criminals shouldn’t be subjected to justice, but rather be helped to commit further crimes.

    Otherwise why does there clearly exist no idea among them other than to reflate the bubble and restore the status quo ante?

  18. It’s quite amusing all the debate about carrots and sticks when the bankers are essentially safe in a castle with a case of Snickers bars. They don’t fear sticks and couldn’t care less about carrots.

    I first came to this blog because of Simon’s excellent piece in The Atlantic in which he posits the capture of the government by the banks. This rings true enough that I take this as a given in further discussion, and thus cannot see any way in which this system can fix itself from the inside.

    The banks own the government. There is no political will for anything but window dressing, to prevent the rest of us from seeing the sordid realities happening in private.

  19. Reckless behavior is punished even when no harm is caused. Anyone with a speeding ticket or a fine for running a red light knows that, and anyone with a drivers license should know it. And there are quite a few spending their time in jail this very moment just because they lost in the lottery of life. They had the small slip of concentration just as the kid ran out in the street, instead of hundred meters down the road. And physicians can tell you all you need to know about malpractice. I do not see what is so special with being a banker that even discussing criminal charges is ridiculed.

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  21. James – The problem with scaling back the business judgment rule is the difficultly created by hindsight. It is extraordinarily hard to tell what was “unreasonable” at the time when analyzing complex business decisions. While it isn’t hard to divorce the behavior from the consequences when deciding whether a driver was negligent, a there is almost no way (absent a knowing standard) after the fact to tell if a business risk was taken negligently (or recklessly). The reason is that unlike drivers business exist to take risks. Should there just be strict (criminal) liability of risks that don’t pay off?

  22. I’m generally no conservative, but I am really skeptical of any “solution” that increases incentives for class action (or even non-class) litigation. Litigation is an expensive blunt instrument that is easily abused, especially when second-guessing past decisions.

    It is far cheaper (for society as a whole) to use actual government regulation and enforcement.

  23. What are you talking about? Criminal prosecution for white collar crimes happen all the time. For a few high profile examples, see Martha Stewart and Richard Scrushy. If you want to include cartel conduct, the list of both companies and individuals who have been prosecuted gets even longer.

    The question isn’t a lack of criminal prosecution for white collar crimes, it is whether to criminalize business judgment.

  24. j0hncap0ne

    “And juries decide whether you were being negligent with the benefit of hindsight; they know that the baby stroller was in the intersection, which you had no reason to know when you took the turn (and was highly unlikely, since it was late at night and raining). That’s just the way the law works.”

    You’re misstating the law here. For you to be liable for negligence, the jury must find that you “should have known” there was a stroller in the intersection. That analysis is essentially whether a reasonable person would have been aware of the risk. What your describing is strict liability.

  25. The problem here is that, by some definitions, banks are no longer operating as businesses, but as some quasi-government sponsored entity. The government has effectively removed the possibility for failure, so normal business judgment can no longer be assumed to apply.
    We have created a monster, and many good people here and elsewhere are banging their heads together trying to invent a way to restore a downside balance to an industry dominated by a few banks that now know they will not fail.

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  27. RICO could be applied. In China they just execute these white collar perps and call the family to come down and take away the body bag.

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  29. I love the term because it so closely matches the criminal offense after which it is coined: Bankslaughter kills innocent investors, and does not involve intent, but rather rational imprudence (the same as manslaughter). We definitely need to develop a criminal penalty for malfeasance arising from the failure to perform prudently within the rational universe which includes innocent bystanders (as in our latest financial crisis vis-a-vis the development of investment vehicles where the risk was intentionally hidden by the creators of the risk). I have always felt that it is dangerous to attempt to legislate morality, but in some cases it is justified. This is one of those cases. If such a law could be instituted, and financial rewards provided to whistle blowers, we might have to make a lot of court space and prison space available.

  30. Pingback: The Baseline Scenario | EthicalMarkets.com

  31. Is this slaughter of banks or banks laughter?

    I think TBTF banks are laughing fit to bust as they are on a win-win game

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  33. I assume this is humor on your part.

    The family has to pay a fee to the Chinese government for the price of the bullet used to execute criminals. No joke. They’re not too sentimental about human life over there. They’ve killed more of their own people (mostly through starvation) than any other nation on the planet. Mao is still scene as a hero for not “bending to the will of foreigners” by excepting food from the outside world.

    Mr. Collier and James’ bankslaughter idea is great. But as for your idea of RICO I don’t think we need to be copying too many ideas from China. Unless you want to slave all day for greasy noodles and formaldehyde flavored beer, like 90% of the Chinese do now. In which case, be my guest.

  34. How about the simplicity of losing your job when you make huge mistakes at work? Not bonuses, bailouts, and bigger positions. Wow, what an unusual idea. And if fines and/or criminal and/or civil charges follow, maybe, just maybe, justice will be served and the next big job won’t be around the corner. And if someone wants to take a chance again on the employee, they atleast have been warned. Society might be a little safer and definitely more aware that you PAY TO PLAY. WE WANT CHANGE!

  35. Art at 12:09 is spot on. Tort law does not speak to criminal behaviour. Insofar as criminal law is concerned, the concept of ‘guilty mind’ continues to rule the day whcih rules out criminalising unintentional bank blow ups. so, we are back to torts and negligence but, of course, it is not clear who the fiduciary duty is owed to: the public at large? this is rather abstract…

  36. Socially Beneficial Risk:
    Noun. Risk to people I don’t socialize with.

    It’s easy to twist words, but frankly I think this is exactly what that term means.

  37. Not sure this is right. It’s not that you should have known, it’s that there was a duty of care that was breached.

    Strict liability would be if your car splashed the baby and the baby died from it, assuming there was no duty of care to avoid splashing babies.

  38. geaugailluminati

    This Is Not a Poem

    “Things aren’t what they used to be
    and they never were.” Will Rogers

    John Bennett

    Have things
    ever been
    different?
    Sure they have.
    Way back before
    fire when
    everyone’s concern
    was clubbing a
    beast to
    the ground &
    devouring its
    innards.
    But whoever
    put together the
    first organized hunt
    had an eye
    on the future–
    he saw the
    labor of
    others as a
    commodity.

    This was
    the beginning of
    mankind’s
    first great
    schism,
    & the gap
    has grown until
    now there are
    two separate
    species–
    bankers &
    credit card holders.

    Yes, it’s a
    simplification,
    but there’s
    no need to
    get complicated
    to get to
    the core of things.

    There’s no way to
    make poetry
    out of
    such a
    situation.

    Which
    sums up what’s
    wrong with it.

  39. That’s good, although inaccurate in detail.

    Anthropological evidence shows that division of labor, social stratification and wealth accumulation began with agriculture.

    This was the original sin which began the nightmare of history.

  40. Too simplistic an analysis. On the rainy road there is only the driver and the wet pavement. How do you take into consideration (in our current mess) – legislators that provide the enabling framework, and in fact encourage inappropriate financial action, ignorant, or manipulative, real estate buyers, rating agencies that don’t understand risk, etc.

    This seems to be part and parcel of our cancerous – someone has to pay because I was too stupid to pay attention – society.

  41. Pingback: WSJ Editorial Page Favors “Bailout Tax” on Large Financial Institutions « The Baseline Scenario

  42. Pingback: Charging a ‘Bailout Tax’ on Big Banks

  43. Well … I also only have one year of law school under my belt. But it wasn’t at Yale, it was at University of San Diego, where we do learn things. While “bankslaughter” as a concept sounds well and good, how can you even set this up as a crime for prosecution. How would you apply “reckless” and “negligence” to the industry? Who do you charge? Under what circumstance could you go after a CEO or other Execs for the actions of their trading desks and collateralized bond underwriting offices? How do you draw the lines of recklessness and risk? It’s not as easy a manslaughter, and I say easy only lightly since you know how difficult such a simple legal concept as manslaughter can be for a jury.

    There is really only one realistic way to deal with bank failure, stop rewarding it. I hate to sound like a simple “capitalist” but there is a lot of truth to the idea that people will not take unnecessary risks when they know nobody will rescue them.

    Then this brings up the “too big to fail” concept. “Make them smaller” was the best response to that. I don’t take Corporate law until fall (with Prof. Frank Partnoy!) and Antitrust is about a year out, but I think we can find plenty of legal routes to deal with this BEFORE we have a repeat of 2008 rather than try to criminalize the lines an industry is supposed to get close to but not go over for the sake of prosecuting those that lost their bets AFTER the crash.

    And I’ll be honest, there are PLENTY of laws the government could be utilizing to go after these firms. I think a better question to ponder is why aren’t they? In all those trillions lost, no one was involved in fraud?

    Good post though and I am totally in agreement that we young law students and those in the industry (I also work for a firm devastated by this, rhymes with Bith Smarney) need to find a way to restart this country on Capitalism 2.0