Make a seat at the table

The report of the Parliamentary Commission on Banking Standards titled “Changing banking for good” makes many bold statements about what is wrong with banking but stays very much in the area of timid when making recommendations for changes.  Most of which seem very much like the exercize of “rearranging the deck chairs on the Titanic”.  Take, for instance, the recommendation for changing from an Approved Persons Regime to a Senior Persons Regime.  You will need to read this carefully.  It seems just like the purposeless retitling that has been applied to the FSA.

So what sort of change could make a difference?  How about this:

Banks have been found guilty of taking advantage of a one sided option.  This option grants huge gains to shareholders and employees if risky behavior pays off and has limited downside in the case of a blow up of the risks undertaken.  Much energy has gone into seeking to make sure that there is going to be ANY downside in the future, since in the recent past, governments around the globe tended to rescue the investors and many of the employees of the banks that lost the worst.

One of the reasons that banks have become so very risky can be summed up in one word, LEVERAGE.  So a simple step that would cause the whole culture at the bank to immediately swing around towards the caution that seems desired would be to give the providers of debt capital a seat (or several) in the board of directors.  Then number of seats going to bondholders would be proportionate to the proportion of capital provided by the bondholders.  The bondholder seats on the board could be capped at 1 less than a majority for a bank that was leveraged at a higher level.  Or they might be set according to the percentage of net income before the cost of debt servicing that is theirs.  That perhaps makes the most sense, since the riskiest firms are pledging the highest percentage of their income to their debt servicing.

The risk committee of the board could be chaired by one of these bondholder directors.  For firms above a certain percentage of debt financing (perhaps half way to the 49% position described above) the Risk Committee chair could have the power of the Veto as wielded by the Tribune of the Plebs in ancient Rome.

The bondholders would not want to harm the company, but they would have a very strong interest to keep the bank from making any of those highly risky decisions that would wipe out the debtholders stake in the firm.  It only makes sense that if the majority of the earnings of the firm are going to service debt, that the debtholders should be calling the shots.

The idea that a company exists only to enrich the shareholders is a fiction created by university writers in the last 50 years, and has no basis in law or custom.  It was created because it simplified the mathematical models that the financial economists wanted to build.  The model caught on because company management found it to be a convenient way to justify increasing their compensation.

Because, for the large part, bondholders were protected by government bailouts, they have largely continued to fund banks.  But the only way to rationally justify the continual funding of the opaque, highly risky banking enterprises via debt with almost no upside and plenty of possible downside is with a belief that bailouts will continue and will continue to protect bondholders.

If however, bondholders ever became convinced that their money really was at risk, and with the current structure, they would never learn how much at risk (see London Whale and MF Global stories and see if you can find any material disclosures of these risks), then they would either require a much higher spread that actually represented a risk premium for the uncertainty involved in bank risk or a seat at the table.

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Tags: Business, Governance

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