I wanted to bring your attention to a new blog that could turn out to be very important. It’s called The Fourteenth Banker (here’s why) and it’s hosted and written by a current banker who wants to see real change in the industry. This is from the About page:

“Despite being with a big bank, I support reform legislation ending TBTF, separation of Commercial and Investment banking, an independent consumer protection agency and other meaningful reforms.    Why?    I have seen first hand the perversions that happen because of some who believe that the an institution exists for them and the stockholders primarily.    Countless others have been hypnotized by this illusion as well.       Free market idealism is conveniently permissive of unbridled self interest.  I believe in the free market.   In fact, this blog is a free market of ideas and is meant to lead to a free market in banking where institutions self police as a matter of competitiveness.    I have hopes of a free market where being in community in a responsible and consistent way is the path to prosperity, a free market where we recognize that if we take care of the community, the community will take care of us.    It takes a sort of faith.    Or does it?     Is not all successful business enterprise based on providing more value than is consumed?

“That is why we are here.   I invite other bankers to engage in discussion about issues and excesses in our industry and possible solutions.”

The goal of the blog is to provide a forum for people within the industry who are dissatisfied with both its behavior over the past decade and its stubborn refusal to change its ways in the wake of the financial crisis. Posts include coverage of misdeeds by the financial sector, as well as an inside perspective on issues such as breaking up banks.

Banks are very large organizations that include many different people with different political, moral, and business ideas. I am sure there are many bankers who are upset with the way their companies have taken advantage of customers, investors, creditors, and taxpayers, and who want the industry to change. However, many banks have attempted to suppress any attempt at real dialogue by issuing blanket gag orders for their employees. The Fourteenth Banker could help make it possible for bankers to engage in that debate.

“Big banks are bad for free markets,” economist Arnold Kling (who usually blogs at EconLog) begins in the conservative flagship National Review, and it only gets better from there. “There is a free-market case for breaking up large financial institutions: that our big banks are the product, not of economics, but of politics.”

Like other conservative economists, Kling uses Fannie Mae and Freddie Mac as an example of financial institutions that grew too large through a combination of lobbying expertise and government guarantees . . . and frankly I agree with him. But he is equally unsparing of other large banks that were supposedly “pure” private actors but turned out to have their own government guarantees.

Kling points to various government policies that have favored the growth of large banks. But rather than simply saying that this means that government should stay out of the markets, Kling says that the problem is one of political economy:

“In recent decades, the blend of politics and banking created a Washington–Wall Street financial complex in the mortgage market. . . . During this period, Wall Street firms were able to shape the basic beliefs of political figures and regulators, a phenomenon that Brookings Institution scholar Daniel Kaufmann has dubbed ‘cognitive capture.’ Andrew Ross Sorkin’s Too Big to Fail, which describes the response of the Federal Reserve and Treasury to the financial crisis, leaves the distinct impression that senior bankers had much more access to and influence over Washington’s decision makers than did career bureaucrats.”

Kling’s answer: make the banks smaller. I agree.

Jonathan Chait has an interesting take on Kling:

“I agree with Kling that the ideal solution would be to simply limit the size of the banks. The second-best solution, which is currently being pursued by Democrats in Congress, is to regulate the banks to prevent them from engaging in risky behavior, and/or tax the large ones to reduce the advantage they gain over small institutions that aren’t too big too fail. . . .

“[The large banks] already have so much political power that breaking them up has zero political feasibility. So we’re in a second-best world where it’s regulate, and hope regulation works, or do nothing. My skepticism of Kling’s argument is that, like some principled right-wing arguments that acknowledge climate change, it argues for an ideal solution that lacks any chance of happening, while favoring the status quo over a second-best solution.”

Chait’s point makes sense, but insofar as I have to take sides, I’ll take Kling’s. First, as a general point, I think that it’s not quite fair to hold economists or policy commentators up to a rigorous standard of political feasibility. It’s not like Kling is proposing a legislative strategy for the Democratic majority; he’s just saying what he thinks policy should be, and his proposed policy isn’t impossibly infeasible like “everyone should just be nice to each other.” I’m sure we could have an endless debate in the blogosphere about the relative merits of the ideal and the achievable, so I’ll stop there.

Second, I’m not sure that Kling says he would favor the status quo over more regulation of the sort proposed by the administration. In any case, I certainly would not, and when I criticize the administration for not going far enough, I generally try to remember to say that they are going in the right direction. Simon and I also take pains to say that simply breaking up big banks is not enough and other changes such as higher capital requirements (and a CFPA, which we write about to the point of boring our readers) are also necessary.

Finally, Kling’s goal may not be achievable in this session of Congress, but it may be achievable in the next decade. It takes time to shift public opinion away from the idea that big banks are inherently good. But it’s still the good fight.

Update: Tom Keene asked us how we managed to get book endorsements from both Dean Baker and Jim Bunning. I said that this just shows how opposition to big banks is not a simply partisan issue. Kling’s article spells out why many supporters of free markets–the economic “right”–are opposed to big banks.

I saw a bank ad in the subway yesterday. Basically, it said:

1. If you set up direct deposit the bank will give you $100.
2. If you set up overdraft protection the bank will give you $25.
3. If you activate online bill pay the bank will give you $25.

1 makes sense because (a) it gives the bank more cheap deposits, which are its raw material and (b) it increases your switching costs. 3 makes sense because it increases your switching costs; it may also cause you to give the bank more cheap deposits, since you need money in the account to cover your bills.

2 makes sense because . . . the bank expects to get more than $25 in fees out of the average customer. A single overdraft fee typically costs more than $25. Now people will be making an explicit decision: “I want the $25 now because I don’t think I’ll ever pay an overdraft fee.” (To be fair, they might be thinking, “I already value overdraft protection at $35 per occurrence, so the $25 is just a bonus.” But I doubt many people think overdraft protection is worth $35 per transaction when the typical transaction is a lot less than $35.

There’s nothing illegal about this, and arguably it’s a smart business decision. It just makes things perfectly clear: the banks want those fees so much they are willing to pay you for them.

The rapid bounce-back of some of the big banks (notably Goldman and JPMorgan) has overshadowed (at least on the front pages of major newspapers) the continued plight of the banking sector as a whole. Calculated Risk highlights the FDIC’s Quarterly Banking Profile, which lists 702 problem banks with over $400 billion in assets — the highest year-end figures on both metrics since 1992, as the savings and loan crisis was tailing off.

A few other summary points from the report:

• Profits are small — actually, nonexistent except at larger banks: “The average return on assets (ROA) for all four of the asset size groups featured in the Quarterly Banking Profile was better than a year ago, although only the largest size group—institutions with more than $10 billion in assets—had a positive average ROA for the quarter.”
• Bank balance sheets continue to get worse, with net charge-offs increasing for the twelfth consecutive quarter.
• Lending continues to fall: “Total loan and lease balances declined for the sixth consecutive quarter in a row.” Total bank balance sheets fell by 5.3 percent — “the largest percentage decline in a year since the inception of the FDIC.”
• Concentration is increasing, with 319 banks vanishing due to mergers or failure in 2009.

See also the Washington Post article, where Sheila Bair blames the large banks: “Bair said that the vast majority of the decline was the result of lending cutbacks by the largest banks, which have tightened qualification standards and increased the proportion of money that they hold in reserve against unexpected losses.”

Undoubtedly many small banks are cutting back on lending because losses are eating into their capital and forcing them to contract. But I think what frustrates Bair is that the larger banks — which are more profitable (in part by charging higher fees) and which enjoyed more government support — are also cutting back.

From Stacy Mitchell of the New Rules Project, also on the Huffington Post:

This is something I’ve long suspected based on anecdotal evidence. According to Mitchell, it’s nothing new:

“The Fed’s 1999 report, published five months before the Financial Services Modernization Act passed, found that overdraft fees were 41 percent higher at big banks compared to small. Big banks charged more for almost every fee imaginable, including 43 percent more for bounced checks, 57 percent more for stop-payment orders, and 18 percent more for ATM withdrawals.

“But rather than allow the evidence in favor of smaller banks to guide policy, Congress decided to get rid of the evidence. At the urging of then Fed chairman Alan Greenspan, Congress ordered the Federal Reserve to stop publishing its annual report on bank fees. . . .

“But, as it turns out, the firm that the Fed once employed to gather this data, Moebs Services, has continued to survey fees at more than 2,000 financial institutions. Moebs agreed to share its 2009 data with the New Rules Project. As our charts show, the biggest banks still impose much higher costs on their customers than small financial institutions do.

“Not only are fees lower, but several studies have found that smaller banks and credit unions pay higher interest on savings accounts. In a study published by the Federal Reserve Bank of Cleveland, researchers Kwangwoo Park and George Pennacchi examined data from 1998 to 2004 and found that rates on one-year CDs were an average of 14 percent higher at small banks (under $1 billion in assets) than at large ones (assets of $10 billion or more) and rates on interest-bearing savings accounts were 49 percent higher.”

The article discusses some reasons why consumers continue to pay more in fees and get less interest on deposits. I think it’s a combination of better marketing by big banks, a general lack of comparison shopping, and low fee transparency. (Price competition often bigs and ends at the words “free checking.”) Big banks are also somewhat stickier because they can cross-sell more products, which makes them harder to leave. But it can be done.

Here’s a letter submitted by a reader, originally from Chase, encouraging her to keep overdraft protection on her checking account.

There’s nothing particularly evil about this — banks will no longer be allowed to charge overdraft fees without your consent, and even I will concede that there are some people who might want this service, so now they have to ask for permission. Of course, it’s a pretty hard and misleading sell: they focus primarily on the issue of funds availability (deposits may not be available immediately), and they try to frighten you with “an unexpected emergency like a highway tow.” If you do get a letter like this and are not sure what it means, remember that the bank will not tell you when you are about to overdraw your account, and it will charge you $34 each time, even multiple times per day, no matter how small the overdraft.

I was interested to note that the bank doesn’t even promise that it will cover your overdraft — it says only that it may cover your overdraft, at its discretion. I suppose this makes sense, since they don’t want to cover an overdraft for $100,000, but couldn’t they guarantee it up to some fixed amount? I mean, if this service is supposed to give you peace of mind, how much peace of mind do you get when the bank reserves the right not to cover your overdrafts?

Of course, what banks really should do if they care about customers is come up with a way to give you a choice at the moment of purchase. Most people probably have a credit card or cash they would switch to if their checking account can’t cover their purchase, but some people might want the choice. In an ordinary competitive market, one bank would come up with such a service* and use it to take customers away from its competitors. We’ll see if that happens.

* Some people might object that this is a network issue that individual banks can’t solve. But I doubt that a little bit of creativity could not solve the problem. There must be a way for the bank to send a message back to the POS device — that’s how they reject transactions. They just need a way to get a tiny bit more information into that message, to the effect of “this transaction would overdraw your account — swipe again if you really want to do that.”

Jason Paez points out this Reuters story on the claim that new banking regulations will require an additional $221 billion of capital in the industry as a whole. I would take this a little more seriously if the source for the estimate were someone other than JPMorgan Chase, or even if there were a non-JPMorgan source to back it up.

As it is, I think this counts as another “nice little economy you’ve got there” attempt at hostage-taking or, as Paez says, “a threat levied against the entire non-banking economy if we allow the ‘extreme’ case (using the article’s words) of regulation to pass.” For one thing, I don’t see how any analyst could have come up with any number, given that the regulatory proposals I have seen have no numbers in them. That is, they say things like “capital requirements for large firms should be higher” but don’t say how much higher. (It’s possible I missed something recent here.) So what could $221 billion possibly be based on?

Second, there’s this gem from one of the JPMorgan “analysts”: “In order to return to similar levels of profitability as per current forecasts, we estimate that pricing on all products (retail banking, commercial banking and investment banking) would have to go up by 33 percent.” How many things are wrong with this statement? One, that Paez points out, is that the 33 percent threat assumes an oligopoly that is able to pass on all costs to customers. There is no magic law of economics that says that industries naturally return to some exogenously determined level of profits. (See, for example, our most famous chart, on the ratio of financial sector profits to total U.S. corporate profits; there’s a better version in our upcoming book.) And there is no law that says that banks’ 2007 profit levels are the ones that they are magically entitled to.Take 3/4 of those profit levels (what you get if you don’t let prices go up by 33 percent) and you are still well above long-term historical averages.

Finally, there’s a more substantive issue behind this self-interested fear-mongering. We just lived through a decade of excessive borrowing and excessive lending by a dangerously undercapitalized financial sector that resulted in a huge crash. We need more capital in the financial system. If that causes lending to drop because banks behave more carefully, then so be it. We should find a way to manage that transition as smoothly as possible (we want to avoid overcorrecting on the downside), but we should want to get to a situation where we have a stable financial system and a sustainable amount of borrowing. That’s good. If forcing banks to have higher capital ratios is the way to get there, that’s also good.

Allen: “Arianna Huffington has been urigng Americans to move money from big banks to neighborhood banks. Do you think that’s a good idea?”

Geithner: “I don’t, but I do think the following is important that people recognize.”

“But wait, why is that a bad idea?”
“Well, let me say this. Customers of financial institutions should be very demanding in the kind of service they expect, the kind of products they get, the disclosure banks offer, the basic fairness in dealings. So I’m very supportive of customers of banks, of investors in banks, creditors of banks, holding them to very high standards. That’s something that’s very appropriate.”

[Those all sound to me like good reasons to move your money out of big banks. At least, they were for me.]

“Is that campaign hurting?”

“I’m not concerned with her campaign. I agree with the basic principle, again, that we’ve been through a period where I think people are right to expect more of their financial institutions.”

So why exactly is moving your money out of big banks a bad idea?

By James Kwak

In late summer or early fall, Citibank was running a promotion: if you opened a new account or moved a certain amount of money to your bank account, you would get a $200 bonus within three months. Someone I know took advantage of this promotion, but as of Monday he still hadn’t gotten the $200 bonus, so he visited a branch.

“I was given the ridiculous explanation that I didn’t surrender the promotion letter and  that the promotion code NP55 was not linked (?) in the application. I told them that: (1) the letter is not a coupon to be surrendered, (2) I should not have to tell the customer service rep how to process the promotion, (3) there was no requirement that the letter even  be presented (just go to a financial center, it states), and (4) the code only needed to be mentioned if applying by phone. They called me back in the afternoon and asked me to come back this morning. They first offered me some ‘thank you’ points, but I stood my ground.  After calling several places they finally reached a Texas office that would further research my problem. “

Eventually, he got a letter saying that Citibank would give him the $200 credit.

I’ve often wondered about situations like this: Is this just garden-variety incompetence, where the marketing folks think of a promotion and the computer guys program the systems wrong? Or is it a sinister design, in which the company decides to pull a bait-and-switch, and will only make you whole if you complain? (This goes far beyond banking. Think about any situation where you were overbilled, and after spending hours complaining you only ended up where you should have been in the first place. I’ve always thought there should be a treble-damages rule or something like it for overbilling, because otherwise companies have an incentive to overbill everyone all the time, especially if they are near-monopolists like the cable company.)

I’ve generally leaned toward incompetence, because I think if a company actually did have such a sinister plan, it would leak (because lots of people would have to know about it). But maybe it’s something in between.

Paul Kiel of ProPublica has uncovered multiple cases where homeowners are not getting their trial loan modifications made permanent. That’s not news. What is news is that the reasons the banks are giving for not making the modifications permanent are complete bogus! One person had his modification rejected by JPMorgan Chase because he made a statement that he expects his income to eventually recover; another was required by Wells Fargo to update his documentation during the trial period and then put into a second trial period because his income went up by $80 per month. (If you’re wondering why this matters, the big reason is that this way a bank can string you along making you think you’ll get a modification before finally rejecting you; if they rejected you up front, you could have walked away and saved yourself the payments in the interim.) In both of these cases, this violated Treasury Department guidelines for the loan modification program.

Here’s the thing. Jamie Dimon and John Stumpf are not reviewing documents and rejecting people’s modifications. These decisions are being made by first- and second-line servicing center employees, who are following instructions they got from . . . somewhere. What’s more remarkable, official spokespeople for both banks are cheerily giving bogus reasons for failing to make modifications permanent, unaware (until busted by ProPublica) that they are violating the Treasury Department’s rules!

So someone is taking the trouble to create inaccurate instructions for the servicing centers and give inaccurate talking points to the PR department. It could be pure incompetence, I guess. But it could be something in between–incompetence through conscious inattention. The bank’s senior executives make the decision to participate in the loan modification program, but then they don’t try very hard to make sure they are following the rules. They know that if they have a messed-up process, they can save on internal costs, and they can also drag out the trial modification periods, which means (a) more payments they wouldn’t have gotten if they rejected people on schedule and (b) longer before they have to write down the loans in question on their balance sheet. So they aren’t consciously giving orders to break Treasury’s rules, they’re just not trying hard to follow the rules, staff their servicing centers properly, train their people sufficiently, and test their computer systems thoroughly. And that way there’s never a smoking gun; instead, they can just say their servicing centers are swamped and they’re having trouble implementing new processes fast enough. (Wait! That’s what they’ve been saying about this very program for months!)

There doesn’t even need to be intent here (although there could be). Companies focus on the things they think are important. During the financial crisis, all the banks were focusing on their cash levels every day, and I’m sure they did a very good job at it. They don’t focus on things they think aren’t important. It seems like JPMorgan Chase and Wells Fargo are not focusing on their loan modification programs, and Citibank is not focusing on delivering on its promotions, just on using those promotions to suck cheap deposits onto their balance sheet. If that ends up helping their bottom line, then so much the better for them.

By James Kwak

“‘How dare he?’ Wheeldon now says. ‘Markets will decide if something is too big or too small. It’s not for an individual, however powerful, to slam and damn nearly 1 million people.’”

Do we really need to point out that markets don’t always make the right decisions? Markets didn’t break up Standard Oil or AT&T–people did. And how is it wrong for public figures to be publicly stating their beliefs about what the objectives of public policy should be?

But the point of this post isn’t to single out another free-market zealot who apparently doesn’t think about the words he is saying. It’s to talk about John Paulson and Malcolm Gladwell.

On pages 179-82 of Greg Zuckerman’s book The Greatest Trade Ever (in the pre-publication version that Simon got for free), he describes how Paulson helped design CDOs so that he could short them (by buying CDS protection on them). The issue was that Paulson wanted to place as big a bet as possible against the housing market, and he wanted that bet in as concentrated a form as possible. He wanted to expand the set of assets that he could buy insurance on, and make those assets as toxic as possible. He was even willing to buy the equity (lowest-rated) slice of the CDO, so that the high returns on the equity would help pay for the CDS protection until the roof caved in. So his team would select mortgage-backed securities that they wanted to be bundled into a CDO; the bank would modify his selections, get the CDO rated, and then find counterparties willing to insure it so that Paulson could buy insurance from them. Some banks refused to participate; others, including Goldman Sachs and Deutsche Bank, went along.

Is this transaction socially useful? And is it ethical?

The main purposes of the financial system are processing payments and financial intermediation (conversion of savings into investment). Clearly neither one is happening here–at least not via the CDS transaction, which does not provide credit to anyone in the real economy. However, there’s another defense you can fall back on, which is that this transaction provides additional liquidity. Because it allows people to express their views about particular securities (mind you, securities that didn’t exist until Paulson got involved), it improves price discovery; and because more transactions are taking place, it makes it easier for investors to get in and out of positions (again, that argument is weakened since the transaction is just creating new, illiquid securities, not increasing liquidity for existing securities). On balance, though, I’d say the social utility is pretty small at best. It’s helping Paulson short the housing market, which should have the salutary effect of putting downward pressure on the bubble, but only by allowing someone else to go long on the housing market, which has the opposite effect.

Still, though, I wouldn’t say Paulson was doing anything unethical. His job is to make a lot of money, and he was looking for the most direct way to do it. The more interesting question applies to the bankers in the middle.

Compare this to two other transactions. In the first transaction, a banker sells his client a share of stock in an IPO. In that case, there is definite win-win potential: the company needs capital and is willing to pay a high (expected) rate of return and the investor wants that high rate of return. Although you can quibble about what the stock should be priced at, there’s no inherent conflict of interest in raising money for a company and selling its shares to investors.

In the second transaction, a broker convinces his client to buy a share of stock on the secondary market. Now this is a zero-sum transaction; if buying it is a good deal for one person, selling it is a bad deal for someone else. But here the broker is only representing his client; the share will be bought on an exchange, and he has no idea who is going to sell it. So while there is certainly room for unscrupulous brokers who convince clients to buy lousy stocks solely for the commissions, there is no inherent problem with this situation.

In the Paulson example, though, the same bank is working with Paulson to create a toxic CDO and convincing its client on the other side to buy or insure that CDO. Not only is it a zero-sum transaction, but it’s a zero-sum transaction between the bank’s clients. (This applies to many derivatives transactions, of course.) Now plausibly this could be in the interests of both sides, depending on their existing risk profiles; if Paulson owned billions of dollars of beachfront property in Florida, he might be shorting real estate as a hedge, and the investors might want to be long real estate because . . . well, who knows.

In any case, there isn’t anything necessarily unethical about this practice. If the bank clearly describes the transaction to the investor, and discloses that it has a client taking the other side (who, in this case, helped design the transaction), then the investor can make his own decision about it. Basically, it’s like placing a bet with a sports bookie. You know that the bookie is taking the same volume of bets on the other side (that’s how the line is set), and you know not to trust him if he tries to talk you into a bet, because you know he doesn’t have your interests in mind; he just wants his cut.

But what did the banks say? If they said, “You’re betting against Paulson, he’s pretty smart, you’re pretty smart, let the best man win,” then that’s fine. But if they said, “This guy Paulson, he’s nuts, we all know housing isn’t going to go down, just take his money,” then that’s a problem, at least in my opinion. Because if you’re a broker and you’re connecting two parties in a deal, you shouldn’t be arguing to both of them that they are getting the good end of the deal, even if it’s two different people at the bank doing the arguing. So this is maybe something for that Financial Crisis Inquiry Commission to look into: how were these things sold?

In the long run, the simplest solution would be for everyone to realize that their banks are not on their side, and that the famous “long-term greed” of Goldman is gone forever, replaced by the more plebeian short-term greed.

(Malcolm Gladwell will have to wait for another post.)

By James Kwak

The idea that the level of inborn talent, hard work, dedication, and intelligence you need to be a banker is even remotely comparable to that of, say, NBA basketball players is ridiculous. But leaving aside the scale, there are some similarities. Most obviously, athletes on the free market–those eligible for free agency–are overpaid. John Vrooman in “The Baseball Players’ Labor Market Reconsidered” (JSTOR access required) goes over the basic reasons, but they should be familiar to any sports fan. There is the lemons problem made famous by George Akerlof: if a team gives up a player to the free agent market, it probably has a reason for doing so. There is the winner’s curse common to all auctions: estimates of the value of players follow some distribution around the actual value, and the person who is willing to bid the most is probably making a mistake on the high side.

Another common factor is the mistake general managers make in overpaying for luck. Take any group of .265 hitters, give them 450 at bats, and a handful will hit .300. On the free agent market, they will be paid like .300 hitters, especially if they are young and they do not have a long history of hitting .265 behind them. This is the exact same as one bank making a huge offer to a trader from another bank who just had a great year.

For another, the apparent productivity of a player in a team sport is largely due to his team and cannot simply be reproduced individually. John Vrooman in “The Baseball Players’ Labor Market Reconsidered” cites the sad case (for New York Mets fans, of which I am one) of Bobby Bonilla, who racked up spectacularly numbers hitting ahead of Barry Bonds for the Pirates, but flopped with the Mets. The same trader who makes big profits at Goldman based on its low cost of funding, sterling reputation, and tremendous client connections will not necessarily do nearly as well on his own.

Finally, while there is a strong relationship between pay and past performance, there is only a loose relationship between pay and future performance. Look at the teams that won the World Series between 2000 and 2009: Arizona Diamondbacks, Anaheim Angels, Florida Marlins, Boston Red Sox, Chicago White Sox, St. Louis Cardinals, Boston Red Sox, and Philadelphia Phillies. Only the Red Sox were among the sport’s traditional big-market teams. Yes, there is a correlation between payroll and number of wins (the Yankees do win the World Series more than other teams), but the random factors play a big role as well.

So yes, bankers are like athletes. Their individual contributions are overrated relative to their supporting environments; they are overpaid; they are paid based on where they randomly fall in the probability distribution in a given year; and paying a lot for bankers is no guarantee that your bank will be successful in the future. Team sports, like banking, are an industry where the employees capture a large proportion of the revenues. And one with negative externalities, like upsurges in domestic violence around major sporting events. Neither one should be a model for our economy.

By James Kwak

I was talking to Simon this weekend and he said, “Why a year? Why is compensation based just on what you did the last year? That seems arbitrary.” When I asked him what he would use instead, he said, “A decade,” so I thought he was just being silly. But on reflection I think there’s something there.

Most approaches to solving the compensation problem focus on changing the way the bonus is paid out, not the way it is calculated in the first place. Many people think that bonuses should be paid out in retricted stock that (a) vests over five years and (b) cannot be sold for some period of time after it vests. (This is already the case for top executives–but not most employees–at many big banks.) The goal here is to tie the eventual payout to the long-term performance of the company, via its stock price.

This is better than all cash, but it still has a few problems. For one, the top executives at Bear Stearns and Lehman Brothers already had this type of bonus payout, and it didn’t help. For another, tying managers’ incentives to shareholders isn’t necessarily what you want when it comes to highly leveraged banks, since shareholders also have the incentive to take on too much risk (since they can shift losses to creditors or the government). (For this reason, Lucian Bebchuk has suggested tying long-term compensation to a basket of securites that includes not just common stock but also preferred stock and some kinds of debt.) In addition, this type of payout structure wouldn’t change the incentives for individual traders, since their bonus is calculated based on the one-year performance of their individual book, and then paid out depending on how the entire company does; even if those trades blow up the next year, chances are they won’t affect the stock price that much.

Clawbacks in future bad years are another idea, but at least as proposed by the Obama administration, I think they would only apply in cases of material misrepresentation. Also, it’s hard to claw money back from people who have left your company. In the business world generally, sales compensation agreements often have clawback provisions, but it’s generally understood that you’re not going to sue your former employees to collect on them. (Besides, often the money has already been spent.)

Simon’s idea (at least as I’ve thought it out) is to change the way the bonus is calculated in the first place, instead of (or in addition to) the way it is paid out. He’s right: why should your bonus be calculated every 365 days and based on the last 365 days’ results, weighted equally? For one thing, this kind of lumpiness encourages behavior that is bad for the company; think about all those discounts that salespeople give at the end of a quarter or a year trying to make their quota. More important, Simon’s main point is that December 31 is just too soon to determine how well an individual did during that year.

Instead, what about making your 2009 year-end bonus based on your performance in 2006, 2007, and 2008? That is, by the end of 2009 you would have better information about whether the trades placed in those years had turned out well or badly. There are all sorts of variations possible: you could weight the years differently; you could include 2009 (with a low weight because it’s too early to tell); you could do it on a quarterly basis to smooth out the lumps; you could pay out on a quarterly basis; and so on. But the basic principle is that you don’t calculate the bonus until enough time has elapsed to ensure that the employee deserves it. If you wait long enough, you could even just pay it out in cash instead of restricted stock.

The first objection will be that new employees get screwed, since they will get lower bonuses until they have been with the company for a few years. There are a couple possible solutions to that. The one I like less is that for someone who joins on 1/1/2009, his 2009 bonus could have a full-size target and be based on 2009 performance; but his 2010 bonus would be based on two years of results, his 2011 bonus on three years of results, and his 2012 and later bonuses on four years of results.

My preferred solution, though, is that people simply get smaller bonuses (and maybe somewhat higher salaries to compensate) when they switch companies, and only get the big bonuses after they’ve been around a few years. (You can imagine a new equilibrium where bonuses for employees in their first years are lower than today, but bonuses for long-term employees are higher. I’m not saying in this post that total compensation has to go down; that’s a separate issue.) In the technology startup industry, employees get stock options that vest over four years (with a one-year cliff). If you leave after two years, you give up your last two years of options (and unless the company is already public, you have a difficult choice about whether or not to exercise your options). This increases the cost to the employee of switching companies, which is good on two levels. First, as far as the division of the pie is concerned, it benefits employers (shareholders) relative to employees, which would be a good thing for the banking industry (as opposed to, say, the fast food industry). Second, it makes the pie bigger, since companies are more productive if they have more stable workforces. For these reasons, banks should actually want to move to this type of bonus calculation.

Now, how do we get there from here? Like many markets, if one firm changed its policy and the others didn’t, it would be at a competitive disadvantage. (Of course, this problem exists with all proposals to change compensation practices, including the restricted stock ideas.) First, the banks could possibly get there on their own, just like airlines do when they raise prices; one announces a change, and then (sometimes) the others copy it. This could be helped along if one of those famous self-regulatory bodies would recommend this as a new compensation structure. Or if Goldman took the lead; since (I think) it has longer average tenure than most banks, if it changed its policy today, fewer employees would be affected than at other banks; and if you’re just two years into your banking career at Goldman, would you really leave for Citigroup now rather than sticking it out at Goldman until you have the tenure to take advantage of the new policy? Second, we could have legislation. Or third, we could have regulatory action, since the Fed has already said that compensation practices fall under its jurisdiction as a guarantor of the health of individual bank holding companies and the financial system as a whole.

Changing the basis of the bonus calculation is a more direct way of dealing with the current incentive problems than changing the form of the payout. How about it?

By James Kwak

Salmon is skeptical that it will work, because changing your bank is a pain. I can testify that it’s not a lot of hours of effort, but you can’t just sit down and do it in one shot; for example, you need to request direct deposit forms (often paper) from your employer(s), get them, print them out, often mail (!) them somewhere, then check your bank statements periodically to make sure the switch happened. Then there’s the issue that if you go a month without direct deposit many checking accounts will charge you a fee, which creates a problem when switching. (However, at my Bank of America account, even without direct deposit you can avoid a monthly fee by keeping a $1,500 minimum balance.) Killing automatic bill pay and setting it up in your new account can usually be done in one sitting, although you have to remember that some of those payments are initiated by your bank account and some are initiated by the payee. So it’s doable, but it’s a pain.

I think another issue is that while outrage at Wall Street remains high, most people don’t connect the bank in their town with Wall Street, even if it is a branch of Bank of America. When you walk into a Bank of America branch, it doesn’t feel like Wall Street. It doesn’t even really feel evil; it just feels ugly and corporate and inefficient. I suspect it’s still a mystery to many people how mortgages issued by the bank on the corner are connected to CDOs, the housing bubble, and vast trading profits on Wall Street. My hatred of Bank of America is mainly due to the experience I had with them last summer trying to get old bank statements for a client. (I also recently noticed that while there used to be three Bank of America branches in my town–probably because Fleet, which B of A bought in 2004 or so, was itself the merger of three banks–now there is only one.)

That said, I’m all in favor. I recently canceled my Citibank credit card that I had for twelve years (my remaining cards are American Express and U.S. Bank, which isn’t particularly virtuous but at least avoids the big four), and I only have one step left to close my Bank of America account (need to verify that my last direct deposit has switched). I use Greenfield Savings Bank (0.75% on checking, without the hassle of a “reward” checking account) and Peoples Bank (1.5% on savings, and other banks’ ATM fees refunded for checking accounts). (For those in Western Massachusetts, I hear Florence Savings Bank is good too).

Switching banks can also be good for your wallet, since the biggest banks almost always pay the lowest deposit rates (and charge relatively high mortgage rates). I look at Bank Deals when I’m looking for a new account.

Maybe next Arianna Huffington can get everyone to pull their money out of actively managed mutual funds and send it all to Vanguard. Now that would be good for everyone (except a few fund managers, of course).

By James Kwak

Hempton argues that Bank of America and Fannie Mae are estimating extremely different future loan losses, and those differences cannot be attributed to differences in their current performance (the rate at which loans are defaulting now). If I wanted to be provocative I would only show you this quote:

“If Bank of America were to provide at the same rate its quarterly losses would be 50-80 billion and it would be completely bereft of capital – it would be totally cactus. It would be – like Fannie Mae – a zombie government property.” [emphasis in original]

(“Totally cactus” — I like that.)

But to be fair, Hempton actually thinks that Bank of America is being only slightly optimistic and Fannie is being extremely pessimistic. Here’s his interpretation:

“[R]egulators are controlling Fannie in such a way that keeps it down. They are allowing Bank of America to act as if all is well whilst Fannie Mae appears to be a complete zombie. Which I think corresponds roughly to the new policymaker consensus that what is good for big banks is good for America.

“It is clear why BofA has chosen the 13 billion of provisions per quarter – which is that it roughly corresponds to their pre-tax pre-provision income. [Hempton is saying that if they took any more provisions they would be unprofitable.] Moreover – in my view the 13 billion per quarter is not far wrong so the decision is defensible. …

“[A]lmost however I cut it the situation is getting worse for BofA at roughly the same rate as it is for Fannie Mae.

“Except for one thing. The government wants BofA alive. Lots of people want Fannie Mae dead.”

By James Kwak

“[W]hy, given the broader backlash against the big banks and the less-than-inspiring performance they’ve turned in over the last couple of years, are people still sticking with them? What makes this even more curious is that the big banks, which have historically offered their customers worse deals than smaller banks, have not changed their ways: they pay less for deposits, charge more for loans, make billions from overdraft fees, and have jacked up credit-card rates.”

When it comes to retail customers (you and me), Surowiecki highlights switching costs (add your own example) and brand (“It’s nearly impossible for consumers to evaluate how healthy a bank is. So, at a time when banks are failing with some regularity, the size and ubiquity of these big banks is reassuring.”). Free Exchange thinks the issue is the implicit government guarantee:

“[I] bigness is associated with security, then real bank competition means convincing customers, along with everyone else, that the government has a plan to unwind its implicit guarantee for banks and that ultimately the country’s largest banks will be as subject to failure as everyone else. If that can’t be achieved—if real market pressures aren’t ever going to apply—then it may be time to start thinking of large banks as natural monopolies, to be treated like regulated utilities.”

I’m a little skeptical of the brand/security argument, since most people don’t have more than $250,000 (the FDIC insurance limit) in their bank accounts. But maybe people don’t really trust the FDIC, or don’t realize how seamless the process is for them, and they would rather trust the Citibank logo.

The switching costs certainly are high, and I can provide some anecdotal details. I’m in the process of switching out of Bank of America. Moving all my bill payments and direct debits from B of A to another bank was pretty easy, although in some cases I had to call someone to get the right form. Moving my safe deposit box was a pain that cost several hours of time. Moving my direct deposits was pretty easy, although again it required paper forms. The trick was the ATM fees, but I found a checking account (PeoplesBank in Holyoke, Massachusetts, with branches in the Springfield-Holyoke-Northampton area) that refunds other banks’ ATM fees. (In the interest of fairness, I should also put in a plug for my other local bank, Greenfield Savings, which pays 0.75% on checking accounts.)

It can be done. But a bigger question would be, why? I feel like I need to as a matter of principle, given my well-known positions on this issue. But I don’t expect the average person who is frustrated by big, unfriendly, bailed-out banks — even the average reader of this blog — to invest the few or several hours it takes to switch. Most people probably don’t have enough money in their deposit accounts for the higher rates you can get at local banks to matter. When it comes to most political issues, I think most people feel individually helpless; when it comes to Too Big To Fail, which, let’s face it, is a pretty technocratic issue, I suspect we feel even more helpless.

Update: One reader wrote in to say that Florence Savings Bank (also in Western Massachusetts) also refunds depositors’ ATM fees incurred at other banks.

By James Kwak