06/13/2012 08:08 am ET Updated Aug 13, 2012

How to Make Banks Less Risky

The announced $2 billion (and counting) JPMorgan trading losses are serving as a catalyst for a national discussion on the effectiveness of banking reforms enacted to date. But it risks getting mired in a debate on the minutiae of exactly what type of trade drove the loss. Would it have been classified as a proprietary trade or not? The complexity involved in trying to identify and prohibit the type of trade is akin to trying to remove a certain color of water from a swimming pool. Instead we should focus on how much water is in the pool overall: that is, how much risk the large US banks should shoulder in total and how best to manage that risk.

An important driver of bank risk is a bank's senior management risk tolerance -- which quickly leads to how their compensation can affect it. The changes made since the downturn have been for managers to take more of their compensation in the stock of their bank and be required to hold it for longer periods of time.

In changing their compensation in this way, we are at best conducting a behavioral experiment and at worst heading in exactly the wrong direction. Here's what we know: equity investors are risk-tolerant and increasingly short-term in their outlook. When investors buy stocks, they are typically focused on how much the stock can rise, and understand that the company must take on risk in order to drive that. Who can forget stockholders drubbing Phil Purcell out of Morgan Stanley in the run-up to the subprime crisis for delivering insufficient earnings growth, when in hindsight his risk-averse stance was precisely the right one for the times? And who can forget the resulting lessons learned by other bank CEOs, that eschewing available growth risked their jobs?

As for loading senior executives up with more stock, who would argue that Dick Fuld's mistakes at Lehman Brothers were because the several hundred millions of dollars of stock he held were not enough? Indeed, equity investors' goals of "stock price performance now" arguably flies in the face of the broader societal need for banking safety and soundness.

But maybe having executives required to hold the stock longer will cause them to take on less risk. But maybe not.

Here's something else we know. Fixed income investors are risk-averse. For them, upside on their investment is limited, since the most they receive back at maturity of the instruments is 100 cents on the dollar. Thus they are laser-focused on avoiding risks that will cause losses, because they don't get any more than that 100 cents if the bets win.

As I outline in the June issue of the Harvard Business Review, if our societal goal is to reduce risk in banks, bank boards should compensate management teams not just in the bank's equity, but a combination of the equity and fixed income instruments of the institution.

Here is how it could work: If a bank is funded with $1 in debt for every $1 in equity (a relatively unlevered position for a bank), executive compensation would mirror that; if the stock component of an executive's compensation today is $2 million, then he would be paid in $1 million in debt and $1 million in equity. The executive would maintain a healthy risk appetite, giving some good amount of his focus to increasing the value of his $1 million of stock.

If the capital structure of the bank shifted to, say, $40 in debt for every $1 in equity (a hugely risky position, circa Lehman 2007), then the same executive's $2 million would be paid $1.95 million in fixed income instruments and $50,000 in equity. As the bank's capital structure becomes riskier, the executive would likely become much more risk averse, focusing more on maintaining the value of the $1.95 million in bonds, rather than increasing the value of the $50,000. This provides a natural hedge.

The value of such a compensation system is not that it will necessarily make the CEOs of these firms behave any differently (though it may), but that as it spreads through the management ranks, it will impact the risk tolerance of the executives running the businesses, the trading desks and the trading positions themselves (including JP Morgan's "Whale"). The entire organization will shift naturally from one of looking to take on more risk to one of looking to reduce risk as financial leverage increases, in opposition to the risk profile of the bank itself. In doing so, the interests of the bond holders, deposit holders and the public at large will be more aligned with the management team. And, counterintuitively, equity holders will be better off, through a cycle, to have their interests less aligned with bank management teams than they appear to be today.