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University of Minnesota
University of Minnesota

Just rewards?

December 29, 2009

Stock market up/down symbol.

Bankers should be liable, as well as rewarded, for their risks 

By Bill Magdalene

Reckless decisions by bankers led to the financial crisis of 2008. It's often suggested that if bankers were stripped of their bonuses, had their salaries capped and were paid in stock that couldn't be cashed for several years, this would motivate them to act responsibly.

Not so, according to University of Minnesota law professors Claire Hill and Richard Painter. They say such measures miss the heart of the problem.

Bankers are reckless because they feel too safe

In a recent paper, Hill and Painter argue that bankers will act recklessly as long as the risks they take don't expose them personally to real financial hardship.

The bankers whose decisions led to the 2008 financial crisis did lose all their stock and stock options. But they kept everything else. Millions from other investments, summer mansions, jets.

"Once five or ten million is squirreled away from firm creditors," Hill and Painter say, "the rest is funny money." To solve the problem, they propose two ways to make bankers personally liable for their banks' debts.

First way: require bankers to enter a partnership agreement

Bankers who earn over $3 million per year would be required to enter a partnership agreement with their bank. That means if the bank becomes unable to pay its debts, the banker is personally liable. Hill and Painter would let the banker protect $1 million in personal assets.

The core idea is old. Before the 1980s, most investment banks (that is, banks that raise capital, trade securities and manage corporate mergers/acquisitions) were general partnerships. Today, investment banks are in corporate form, with limited liability. Hill and Painter would revive the partnership form, but only for key employees.

Second way: pay bankers in assessable stock

All of a banker's yearly income beyond $1 million would be paid in assessable stock. That means if the bank becomes unable to pay its debts, the banker must pay an amount equal to the value of all the stocks received. The value of each stock holding is defined as whatever it was on the day the banker received it.

Again the idea is old. Before the 1930s, some commercial banks (that is, banks that provide checking/savings accounts, etc.) issued assessable stock to directors and officers.

The goal is to protect the public

You've probably noticed that in both proposals Hill and Painter let the banker protect $1 million. That's because their goal isn't to bankrupt bankers. Rather, it's to motivate responsible investment decisions that will protect taxpayers and all who innocently get hurt when financial crises arise.

Note: the word "banker" has been used here to refer loosely to various kinds of employees who play key roles in various kinds of financial institutions ("banks"). In their paper, Hill and Painter go into detail about what institutions and employees would be covered by their proposals, and about legal aspects such as what events would trigger liability and how to enforce it.

But the point is straightforward. Some form of personal liability is needed.

"Bankers who profit enormously from their occupations in good times," Hill and Painter say, "should be prepared to share in the costs borne by the public when the risks they take do not pan out."