When banks fail, executives should have skin in the game

COMMENTARY

CHARLES GOODHEART

About a year ago, three high-profile regional banks failed, raising long-familiar questions about the resiliency and strength of our financial system. While there were disagreements about the role that supervisory lapses and monetary policy played in the failures, there was consensus that these three banks were grossly mismanaged, failing in the most basic lessons of Banking 101.

For a time, as is often the case, it looked as though Congress would take action. In June, the Senate Banking, Housing and Urban Affairs Committee responded with strong, bipartisan approval of legislation to increase accountability for executives of failed banks.

Now, even as the risk of additional bank failures looms, this legislation languishes before the full Senate. Congress has apparently forgotten the disruptions caused by last year's failures and the tens of billions of losses for the FDIC.

It needs to act.

Executives of all three failed banks added low-yielding securities and loans to their balance sheets even when it was clear interest rates would rise, causing those assets to lose substantial market value. The executives failed to effectively hedge that risk, while also relying heavily on unstable, uninsured deposits which were too large for FDIC insurance.

Most egregious were senior executives at Silicon Valley Bank. They left the position of chief risk officer vacant for eight months, while selling millions of dollars' worth of personal stock holdings just weeks before the bank failed. The combined costs of all three failures to the FDIC was estimated to top $31 billion, or about 25 percent of the FDIC's total reserves.

Those costs are now being made up through assessments on other FDIC-insured banks which in turn may be passed on to bank customers.

The Senate legislation, known as the Recoup Act, would hold bank executives responsible for their mistakes. Most importantly, if a bank larger than $10 billion fails, the measure would give the FDIC new authorities to recoup two years' worth of senior executives' compensation. This includes incentive-based and equity-based compensation, as well as any gains realized by executives if they sold stock within that time period. It would also authorize regulators to impose additional financial penalties on executives whose conduct was reckless or egregious.

The bill passed the Banking Committee by a vote of 21-2, with statements of support from its Democratic chairman, Sen. Sherrod Brown, of Ohio, and ranking Republican Sen. Tim Scott, of South Carolina. The only argument advanced against the measure was that expanded liability for bankers would make it harder to attract people to work there.

But unlimited liability was the norm for bank executives during much of the 19th century, and this did not deter quality individuals from entering the banking profession. Instead, unlimited liability for bank executives inspired the kind of trust which in turn brought in more investors and depositors.

To be sure, there were lapses in regulatory oversight of the three banks that failed. But bank examiners are not in day-to-day control of the institutions they supervise. Even the best examiners will not always be able to prevent failures caused by inept management. Regulators also impose capital requirements on banks to give shareholders incentives to monitor for risk, thus reducing insolvencies and the need for government bailouts. However, as outsiders, most bank shareholders have no direct control or influence over management decisions beyond selling their shares.

Management insiders, however, do have the information and decision-making authority to make sure a bank is properly run. The Recoup Act's expanded liability gives them a significant personal stake in their banks' survival.

It creates an elegant alignment of their incentives with prudent risk management, an important supplement to bank supervision and capital requirements.

Serious challenges remain for the U.S. banking system. A deteriorating commercial real estate market, interest rate uncertainty and the lingering risk of recession require bank executives to be laser-focused on strong risk management. Bank failures can impose significant costs, not only on the FDIC, but on shareholders, bondholders and large depositors not protected by the FDIC. Most importantly, they can be disruptive to the communities the bank serves.

Bank managers need to be more strongly incentivized to prioritize safety and soundness over reckless risk-taking in pursuit of short-term profits. Though executives of Silicon Valley Bank lost their jobs, they have not had to give up the generous compensation they received during the years preceding SVB's failure.

Greg Becker, SVB's former CEO, received annual compensation of $10 million, which he has defiantly refused to give up, even when pressed during a Senate hearing.

Even with the Recoup Act, some banks might still fail. But by forcing culpable bank executives to have more skin in the game, the Recoup Act should significantly reduce the number of failures.

And if that happens, the public can take some satisfaction in knowing that the persons responsible will be held to account.

Sheila Bair is the former chair of the Federal Deposit Insurance Corporation (FDIC).

Charles Goodheart is Emeritus Professor in the Financial Markets Group at the London School of Economics.