How to Cure Too Big To Fail

The Dodd-Frank Act’s worthy objectives were to improve the safety, resilience, efficiency, and transparency of our financial system. Yet the law has drastically diminished the credit available to low-income Americans – the very people it was supposed to help. Equally important, community banks, which service disproportionately large shares of agricultural, residential mortgage, and small business loans, have been particularly adversely affected by Dodd-Frank. Specifically, since Dodd-Frank, there are 2,400 fewer small banks and community bank small business lending has dropped 21 percent. The CHOICE Act, recently passed by the U.S. House of Representatives, attempts to address many of these shortcomings.

Perhaps the most important goal of Dodd-Frank was to make too-big-to-fail banks a thing of the past. However, senior policymakers believe that many big banks are still too big to fail. For example, the Federal Reserve Bank of Richmond documents that the federal government’s financial safety net still covers about 60 percent of the financial system’s liabilities – unchanged from before Dodd-Frank. Also, the too-big-to-fail issue has come up repeatedly in congressional hearings. In recent work, we propose a solution to the too-big-to-fail problem that can be implemented with minimal or no additional regulations, only the intervention of corporate board members and institutional investors in these big banks.

While some have argued that incentives generated by executive compensation programs led to excessive risk-taking by banks contributing to the 2008 financial crisis, there are more important causes of the financial crisis of 2008. Specifically, public policies regarding home mortgages are perhaps the single most important cause of the financial crisis of 2008. As is the case with most public policies, the intent of those regarding home mortgages was honorable – its goal was to increase home ownership by those who could not otherwise afford home mortgages. However, these public policies also encouraged an incentive compensation structure in the big banks focused on generating short-term profits at the cost of large longer-term losses.

We find that incentives generated by bank executives’ compensation programs contributed to excessive risk taking. To address these misaligned incentives, we recommend the following compensation structure for bank executives: incentive compensation should consist only of restricted stock and restricted stock options – restricted in the sense that the executive cannot sell the shares or exercise the options for one to three years after his or her last day in office. Also, we recommend incentive compensation for bank directors should consist only of restricted stock and restricted stock options – restricted in the sense that the director cannot sell the shares or exercise the options for one to three years after his or her last board meeting. This incentive compensation package will focus bank managers’ and directors’ attention on the long run and discourage them from investing in high-risk, value-destroying projects. We provide solutions to many of the caveats that arise, specifically regarding under-diversification and loss of liquidity for these executives and directors.

Our recommendation for executive (and director) compensation is based on our analysis of compensation structure in banks. The aforementioned equity-based incentive programs lose their effectiveness in motivating managers (and directors) to enhance shareholder value as a bank’s equity value approaches zero (as they did for the too-big-to-fail banks in 2008). Additionally, our evidence suggests that bank CEOs sell significantly greater amounts of their stock as the bank’s equity capital (tangible common-stock-to-total-assets ratio) decreases. Hence, for equity-based incentive structures to be effective, banks should be financed with considerably more equity than they are being financed currently. Our bank capital proposal has two components. First, bank capital should be calibrated to the ratio of tangible common equity to total assets (i.e., to total assets independent of risk) not the risk-weighted capital approach that is at the core of Basel. Second, bank capital should be at least 20 percent of total assets. Also, total assets should include both on-balance sheet and off-balance sheet items; this would mitigate concerns regarding business lending spilling over to the shadow banking sector.

Greater equity financing of banks coupled with the aforementioned compensation structure for bank managers and directors will drastically diminish the likelihood of a bank falling into financial distress; this will effectively address the too-big-to-fail problem. Our market-based solution (greater bank equity, and reforming bank executive and director incentive compensation) will accomplish Dodd-Frank’s worthy objectives without the need for much of the pursuant regulations. Our bank capital reform is also consistent with the essence of the CHOICE Act regarding bank equity capital.

This post comes to us from Sanjai Bhagat, the Provost Professor of Finance at the University of Colorado and the author of the book, Financial Crisis, Corporate Governance, and Bank Capital. The post is based on his recent article, “Financial Crisis, Corporate Governance, and Bank Capital,” available here.