The Simplicity Solution

Will the law prevent another bank bailout if we have a repeat of September 2008? Will it bring transparency to the trading of derivatives? Will the Volcker Rule truly eliminate the ability of banks to make risky trades for their own account? Are all the new regulations burying small and medium-size banks in excessive costs? Or are they ensuring their safety and soundness? No one can say for sure.

The crucial difference between the Glass Steagall Act, the landmark banking reform law that was passed during the Great Depression, and Dodd-Frank, is that the former had an appealing simplicity that Dodd-Frank lacks. Glass-Steagall did one basic thing. It forced banks to get rid of their investment banking arms. Dodd-Frank, by contrast, accepts the complexity of modern banking — and then adds to that complexity with its thousands of pages of regulations. That complexity is something to worry about.

That is why I wrote a recent column about a persuasive paper by Karen Petrou, a banking expert, in which she argued that Dodd-Frank was creating a new kind of risk that she labeled “complexity risk.” And it is why, last week, I found myself drawn to an article in the June issue of The Harvard Business Review that argued for a handful of simpler ways to restrain banking behavior.

The article, entitled “Four Ways to Fix Banks,” was written by Sallie Krawcheck. At 47, Krawcheck has been through the banking wars. She had several high-level jobs at Citigroup, including chief financial officer; most recently, she successfully ran Merrill Lynch’s huge brokerage operation for Bank of America. (She left last September.)

In a nifty bit of timing, her article comes out just as the country is reacting to the news of JPMorgan Chase’s big credit derivative losses. To Krawcheck, the questions posed by the JPMorgan fiasco speak directly to the problems posed by complexity. “The JPMorgan loss is manageable,” she told me the other day. “But it allows us to stand back and ask: ‘What does this say about the banking system?’ ”

To her, it says that even at an institution as well run as JPMorgan, the complexity of banking can be overwhelming. “It appears the trades themselves were so complex that the risks were not well understood,” she said. “The bank management didn’t understand them. The regulators weren’t aware of them. And the bank’s risk management system didn’t pick them up.”

Indeed, in her view, all the talk about whether the Volcker Rule would have prevented the trades is beside the point. To her, the issue is not whether a bank is taking excessive risk for its own account. It is whether the bank’s overall risk profile makes sense — no matter what the purpose. “How much risk do we want banks to take?” she asks. “That is the debate we need to have.”

In her Harvard Business Review article, she lays out a handful of market-oriented ideas that would almost surely pare back the complexity risk posed by banks. My favorite is her first one: top bank executives and senior management should be paid in bonds as well as stocks — and in the same percentage as the bank’s risk profile. Thus, as she envisions it, a bank that had a dollar of debt for every dollar of equity would pay its chief executive half in debt and half in stock. But if the bank was accumulating, say, $30 of debt for every $1 of equity, the executive’s pay would also be skewed 30 to 1 in favor of debt. One would be hard pressed to imagine a more surefire way to focus a banker’s mind on making sure the bank could pay back that debt.

Her other ideas are almost as good. She thinks dividends should be paid as a percentage of earnings — so that if earnings decrease, the bank can retain more of its capital. She says that bank managers should be judged less on the earnings they generate and more on the quality of those earnings — partly because earnings are often a function of interest rates, which bank executives have no control over. And she argues that bank boards should pay much more attention to the businesses that seem to be booming. In banking, those are often the businesses that can cause the nastiest surprises.

It is good that people like Karen Petrou and Sallie Krawcheck are raising alarms about complexity — and putting forth some sensible, and simpler, solutions for making banking safer. Unfortunately, even after the JPMorgan fiasco, it is unlikely that anyone is going to act on them — at least not right now. The Democrats are wedded to Dodd-Frank, while the Republicans care only about putting up roadblocks to Dodd-Frank’s implementation.

Sadly, the only thing that will change that is another crisis. Until then, we’re stuck with complexity.