Bank CEOs Respond To Having More Skin in The Game

As I continue to watch the Financial Crisis Inquiry Commission hearing, my disappointment grows. I really hoped that this would be a productive way for to identify what went wrong and what needs to be done to reform. Unfortunately, a great deal of what's going on here feels witch trial-esque, instead of a legitimate attempt at getting useful answers. But in the sea of accusatory questions about compensation practices and selling clients bad securities, a few of the committee members are stumbling upon some legitimate questions.

One good question was asked by Byron S. Georgiou. He asked whether it would have helped if banks were forced to always hold interests in the securities they sell, which could not be hedged. This sounds vaguely reminiscent of Congress' current ideas of how to reform securitization. As I've said before, this idea wouldn't have helped and could have negative consequences, and the bank CEOs explain why.For starters, as Morgan Stanley's Chairman John Mack says, banks did have skin in the game. "We did eat our own cooking, and we choked on it," he says. That's exactly right. There wouldn't have been a financial crisis if the banks themselves didn't hold billions of dollars in these so-called toxic securities. If they had been required to hold these securities, you would have seen the same result.

Goldman Sachs CEO Lloyd Blankfein says, this was not a failure of incentives, but a failure of risk management. The problem, he explains, was that people didn't know the stuff was toxic.

Mack makes another good point: investors won't like this idea. The SEC generally frowns on investment banks holding back a portion of the securities that they originate. Banks were subject to a lot of criticism for doing this in the late 90s during the tech boom. Investors wanted access to all of the securities and were angered when good offerings turned out to particularly benefit the banks because they held onto the securities. That hurdle could, in theory, be rethought, but it's an interesting subtlety.

The other problem with forcing banks to hold onto securities that Mack explains is one I've also noted in the past. It would reduce the banks ability to do business. Now, some would celebrate that banks have limitations to their size and growth, but this would also inadvertently affect the market in adverse ways. For example, there would be a far lower securitization volume. That means auto loans, mortgages and credit cards would be more expensive for consumers. Corporations would also have a higher cost of borrowing, which would stifle innovation and growth.

I'd draw an analogy as follows: imagine if Wal-mart had to keep some skin in the game regarding the products it sold. For every 100 shirts it sold, it had to hold onto one. For every 100 toasters it sold, it had to hold onto one. Or maybe it just had to take on the risk of those products. For example, if the toaster turned out to be faulty and burned down someone's house, then Wal-mart could be sued. That's crazy -- it isn't Wal-mart's fault. All it did was act as a middleman and facilitate the transaction. The lawsuit should be filed against whoever created the toaster.

The same logic should apply to securities. If a stock goes bad, then blame the company it references, not the bank that sold it. If a mortgage-backed security goes bad, then blame the mortgage originator, not the investment bank who sold the security. The idea that investment banks should be responsible for or bear the risk of all of the products they sell just seems crazy to me, for the same reason most people would agree it would be insane to hold such a standard in other industries, like retail goods and stores like Wal-mart.

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

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