Two University of Minnesota Law School professors, Claire Hill and Richard Painter, have a proposal for fixing America’s banking system: Encourage banks to adopt “covenant banking,” a term Hill and Painter coined for a set of practices that would put the personal wealth and compensation of bankers at stake if something goes wrong. Although Hill and Painter come from different backgrounds—Hill practiced corporate law before coming to the University of Minnesota and is affiliated with the school’s cognitive-science center, while Painter served as George W. Bush’s chief ethics lawyer for two years—both agree that banks need to change. Their book making the case for covenant banking—Better Bankers, Better Banks—will be published in October. I recently spoke to the professors about their idea and what it would take to make it happen. Our exchange has been edited and condensed.
What problem would your idea solve?
Painter: I see two problems: the way banks have been run in an unsafe and unsound fashion, which led to the 2008 financial crisis, and the way banks treat customers and clients and society as a whole.
Hill: Because of how banks have come to operate, their behavior has the potential to do a lot of damage, which is something we saw in very dramatic form in 2008.
You’ve proposed the solution of a covenant bank. What would that look like?
Painter: It’s an attempt, through a contract between the banker and his or her bank, to recreate at least part of the economic relationship—and we also believe some of the psychological dispositions—that bankers had before the 1980s, when investment banks were general partnerships. When investment banks were general partnerships, the partners were personally liable out of their own assets if the bank was insolvent. If a large fine or judgment was imposed on the bank, it came right out of the partners’ wealth directly. Whereas now, we find judgments largely being absorbed by shareholders, with often minimal impact on compensation, much less personal wealth. What we’re trying to do in this contract or covenant between the banker and the bank is say that this employment agreement should have a provision that would impose some measure of personal liability on the banker in the event of the bank’s insolvency. And if the bank were to be subject to a fine or judgment or settlement or administrative action or civil lawsuit for certain categories of misbehavior, a substantial portion of that fine—maybe 50 percent—would come out of the compensation of the more highly compensated bankers reaching back two years and reaching forward two years. So there would be an economic impact on the banker.
Hill: I think the ethos of the general partnership is that you have enormous stake in who your partners are. Not to say bankers don’t have stakes now, but they have it on the upside, which is to do the things that bring in big bucks. It’s not to avoid risk.
Are you saying covenant banking could change the kind of people who are recruited?
Hill: One has to imagine that there is some kind of difference between the people who are attracted to profit at all cost—with the downside being someone else’s problem—and those who are attracted to a much more shared endeavor.
How would covenant banking change both how bankers do business and the banks’ cultures?
Hill: The changes would be, in a sense, hand in hand. It would be in bankers’ financial self-interest to avoid, certainly going over the line, and perhaps getting too close to the line as well. And it would be rather easier to have a system where you’re thinking in terms of “I want to do the right thing.” Part of the reason is, you don’t want to pay, but it just becomes a surrounding ethos.
What would it take to make the covenant banking model happen?
Painter: Regulators have various mechanisms to make this happen. They could say, “Take your choice—it’s either going to be a $500 million fine to the shareholders and tell them why, or a $50 million fine and you take it out of the bonus pool.” I think there are various mechanisms for passing along fines and judgments to the bankers, at least those in the units where the conduct occurred or allegedly occurred. Another way regulators could do this is impose a fine and settle the case on the condition that the fine come out of the bonus pool.