Published in the San Diego Union-Tribune, September 4, 2023
by Neil Senturia
Now tell me true, do you love your bank?
Banking is not as easy as it used to be. For example, in 2023 alone, let’s consider bank failures by Silicon Valley Bank, Signature, First Republic and Heartland, as well as a few other engineered “rescues” by some of the Wall Street big guys.
The basic business of banks used to be lending money. Consider Jimmy Stewart in “It’s a Wonderful Life.” He ran the local bank, Bailey Building and Loan, that held the deposits of the community in a safe place (usually a safe). The era of credit default swaps and long/short mismatches of maturities had not yet infiltrated Bedford Falls.
But stuff happens and there is a run on the bank, and you need to watch the movie to see how it ends. But trust me, misplaced deposits, leverage, consumer hysteria, fear and loathing make for a tale still relevant today.
For guidance on banking and perverse incentives that lead to dumb decisions, I turned to Harvard professors Shawn Cole, Martin Kanz and Leora Klapper. Cole says, “The question of incentives is fundamental to economics.”
They did some research on the 2008 mortgage crisis and found that the kind of bonuses being paid had the effect of distorting the loan officer’s perceptions. When you got paid primarily for originations, you greenlighted a larger number of applications.
It was the intersections of greed and bonuses — the loan originators essentially made “liar loans” based primarily on whether or not the applicant was simply breathing. They knew they were going to fail, but they issued them anyway because they were getting a bonus for every origination.
But here is the kicker. Cole found that it was not just the bonus compensation itself that affected people’s true judgment, in fact, “it was that the prospective bonus made him or her believe that the application was worthy.” Their decision process was delusional, and the incentives “distorted” their judgment.
In other words, at least while the ink was still drying on the docs, the loan officer actually convinced himself that “fish could fly.”
But when the stakes were higher, i.e. the loan officer only got paid if the loan performed, they exerted more effort and made better decisions. “It wasn’t just that they were more conservative, but they were doing a better job of ferreting out bad loans.” Imagine that, a lending officer with skin in the game? Incentives in the rearview mirror may appear closer than they are.
Herewith a story:
A friend of mine, Herkimer, has banked at the same institution for 25 years. He started with them when they were small, he had a personal loan officer, but then they got bigger, and eventually, of course, they got bought by a really big bank. Herk went through five different loan officers.
He had a line of credit for a couple of million which he used from time to time. The reason they gave him a line was that he had multiple more millions in stocks and bonds. Herk was sort of a “player” in town, never missed a payment, and he referred a lot of business. Symbiotic.
Well, the new big bank comes in, and the new loan officer comes to see Herk. He tells him the ballgame is over and that he cannot approve an extension of his line of credit. The loan officer explains that his own compensation, his bonuses are based on assets under management that he brings to the bank. He tells Herk that private banking is not really banking, rather it is client wealth management. And unless he can get Herk’s personal stock account millions under the bank’s management, he doesn’t get paid.
Herk counters that he has several of his other companies at the bank, with strong balances, but he is not leaving the original stock broker who 25 years ago brought him to the dance when he was a nobody and didn’t have those millions.
Herk gets an offer from another bank able to accommodate his desires. But moving accounts is always a pest.
OK, pick a side. You can be the CEO of the big bank or the loan officer or you can play Herkimer. What do you do?
Rule No. 775:
Always ask for the “exception” rate.