Tags: Banking Crisis, banking-sector, Banks, Corruption, Lehman Brothers, Martin Hutchinson, remuneration

How to Cure Western Bankers of "Bad-Banker" Behavior

[Editor's Note: A former international merchant banker who worked in both London and on Wall Street, Martin Hutchinson understands the U.S. banking sector's problems better than anyone else. Here's the Money Morning expert's prescription for curing Western bankers of their risk-seeking behavior - for good.]

By , Money Morning •

Masayuki Oku, the new head of the Japan Bankers Association, recently said that Western bankers did not understand self-control the way Asian bankers did, which was a major cause of the 2008 crash and the Great Recession.

I think he has a point.

Oku's main purpose in denouncing Western bankers for their lack of self-control was to object to the tougher proposed capital rules from the Basel Committee, the global body that sets banking regulations.

The Trouble With Banks

As president of Sumitomo Mitsui Financial Group Inc. (OTC ADR: SMFG), Oku is worried that tougher capital rules will make it impossible for banks to earn an adequate return in the highly competitive Japanese domestic market.

He's right there, too.

In Japan, the Post Bank forms a government-owned competitor to the commercial banks with $3 trillion in assets and access to huge amounts of cheap deposits through the nation's post offices. In a normal market, if all the Japanese banks had to raise more capital, returns on loans would increase so that they all earned a reasonable return. But with a state-owned Godzilla on the playing field, that becomes impossible: Godzilla undercuts everybody.

However, the solution to this is to lobby the Japanese government to privatize the Post Bank, as was originally planned. What are banking lobbyists for, anyway? It's not as if Japanese banks are incapable of losing money. They just do so in "old-fashioned" ways, such as through real estate lending. So a bit more capital won't hurt at all.

Oku has a much better point in relation to Western bankers. He believes that Western banks need more capital than Japanese banks because their top executives get bonuses that are geared too much to short-term results. This causes the Western banker-financiers to lack the self-control that their Asian banking counterparts still possess.

I don't think it's an ethnic thing. If you paid Japanese bankers as executives at the now-defunct U.S. investment-banking-giant Lehman Bros. Holdings (OTC: LEHMQ) had been paid, the Japanese executives would almost certainly start behaving like their Lehman brethren within a few short years.

They would hide assets off the balance sheet, load up the balance sheet with toxic rubbish, gamble wildly in the derivatives markets and leverage their banks to the eyeballs. After all, British and American bankers did not behave like that 30 years ago, when their own incentives were much more staid and conservative than they are today.

In my view, the problem with Western bankers is the amount of remuneration - along with the focus on short-term profits. The biggest offender - the thing that most induces "bad-banker behavior - is the concept of "drop dead money," which is actually so much money that bankers are able to retire at 35 or 40 and live well for the rest of their lives.

The Good Old Days of Banking

In the old days, a fairly senior Western banker made a few hundred thousand a year in today's money. That didn't enable him to live like the international jet set. Nor did it enable him to retire comfortably at 40, because his capital assets would be insufficient to support him comfortably for a 30-year to 40-year retirement (unless he had inherited money, as many did).

That meant that senior-banking executives in their 40s and 50s had a vested interest in keeping the institution alive. The institution would continue to provide them with a moderately opulent lifestyle during their working life. And after they retired, they could maintain that lifestyle - and perhaps even add a splash of wealth - by selling their partnership interests in the bank.

It wasn't much different for top-tier executives. Even partners in investment banks - and certainly top management in commercial banks - worked only normal amounts of hours. The concept of "bankers' hours" in the old days did not mean 90-hour workweeks. Bankers routinely worked 25-30 hour weeks. There were always several good company-paid lunches and a couple of afternoons off at the golf course.

In such an environment, senior bankers maintained a balanced life. They developed interests outside their banks, and they maintained wide social and cultural interests. There was little danger of losing self-control. And there was no incentive to do so.

In today's market, bankers are regularly putting in workweeks of 80 hours, 90 hours, or even more. And few have outside interests - other than the occasional expensive charity dinner.

Their only objective is to make "drop-dead money" before some younger, hungrier banker forces them out, or they find they can't take the pace anymore. Naturally, in such a workplace culture, they take crazy risks in order to maximize their short-term earnings.

"Self-control" is an unnatural act, and seems to go against their self-interests. After all, if they reduced their risks and short-term earnings, they might find themselves in the horrid position of having grown old before they grew rich.

Changes to Make

There is a solution. It will permanently improve Western-banker behavior.

But it will take time to implement.

It will also take time to change the banking-sector's culture.

Money must be made much tighter, so there is simply less ability to leverage. Regulations must be designed so as to ensure that banks manage risks properly, and don't take huge bets that endanger the institution. A lengthy period of low deal flow and modest earnings on Wall Street would not hurt. That slight malaise would bring about the tradeoff between work and outside pursuits. That, in turn, would make it impossible to retire at 35 or 40, while at the same time making it attractive to develop a full range of outside interests.

Sumitomo Mitsui's Oku is right. But the Western banking system must go through several years of high interest rates and depressed markets before it gains the "self-control" it lacks.

[Editor's Note: Money Morning readers are often amazed by Martin Hutchinson's profit-focused instincts - as evidenced by his unerring ability to paint a picture of what's to come. He's able to show us the big profit opportunities that are still over the horizon - while also warning us about the potentially ruinous pitfalls hidden just around the corner.

So it's no surprise that Hutchinson has pulled off a string of forecasting successes in the face of the worst financial crisis since the Great Depression - a financial crisis that, not surprisingly, Hutchinson is widely credited for having predicted and warned about well ahead of time.

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With his "Alpha Bulldog" investing strategy - the crux of his Permanent Wealth Investor advisory service - Hutchinson has managed to combine dividends, gold and growth into a winning, but low-risk formula that has developed eye-popping returns for subscribers.

To take a moment to find out more about the opportunities related to dividends, gold, "Alpha-Bulldog" stocks and The Permanent Wealth Investor, please click here. You'll likely find it time well spent.]

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