Claire Hill and Richard Painter’s new book is the latest addition to their long line of work on the complex interaction between law, economics, culture, and individual behavior in the fast-moving world of investment banking. In this exceptionally well-written book, Hill & Painter target what they view as the fundamental problem with today’s Wall Street: the fact that bankers (a term that denotes mainly investment bankers and other securities industry professionals) are allowed to behave in socially harmful ways, without suffering meaningful personal consequences. Alas, the authors don’t need to try very hard to convince us why this topic is both timely and important. What seems to be a never-ending string of scandals involving large financial institutions rigging prices, misleading customers, and helping clients cheat tax authorities and creditors provides plenty of evidence to that effect. If, after all these ugly revelations, you still trust bankers’ assurances that they are “doing God’s work,” you haven’t been paying attention.
In the book, Hill & Painter explain why, in recent decades, Wall Street bankers so consistently failed the public whose money they purport to manage. While not necessarily breaking new ground in this well-trotted area, the book does a great job of telling a rather impressively comprehensive story of how, in the course of the last few decades, investment bankers gradually abandoned their professional ethos in favor of purely self-serving pursuit of personal profit that is at the core of today’s culture of “irresponsible banking.” Hill & Painter trace the transformative changes in the business model of modern investment banking in the context of the increasingly competitive, globalized, computerized, and impersonal marketplace. One of the central themes here is the loss of bankers’ unlimited personal liability as a result of mass conversions of investment banking firms from partnerships to publicly traded corporations. Hill & Painter masterfully depict how this seemingly innocuous change reshaped the structure and culture of Wall Street from the 1970s on. To this broad-brush picture, they add nuance by dissecting some of the psychological factors driving individual investment bankers to disregard society’s interests and gamble with other people’s money. I found that part of the book particularly enjoyable and insightful.
What makes the book an even more worthwhile read, however, is the authors’ proposed solution to the problem of irresponsible banking. Hill & Painter preface their proposal by stating that an effective solution to problematic behavior in the financial industry must target not only monetary incentives – the focus of many proposed reforms – but also the underlying industry values. Importantly, the authors are skeptical about the efficacy of law as the key engine of an industry-wide normative shift. To them, changes in banks’ business practices mandated by regulation alone are bound to miss the mark, largely because regulators are ill-equipped to stay ahead of the misbehaving bankers. So, if it’s not the law and its agents, then what or who could possibly transform Wall Street’s culture?
The book’s answer to this question is elegant in its simplicity. Hill & Painter propose that investment banks – the corporate entities whose coffers and reputations are directly at stake – impose contractual obligations on their highly paid bankers to bear personal liability for some portion of their banks’ losses from excessive risk-taking or violations of law. This system of “covenant banking” would, in effect, force individual bankers to internalize the costs of their socially irresponsible actions and, consequently, to adopt a more conservative ex ante attitude toward financial and legal risk. It is this last factor that the book’s authors find especially important. Indeed, that’s why they insist on not having bankers’ personal liability depend on individual fault. To illustrate the basic idea, Hill & Painter discuss how such personal liability agreements might work if a bank is insolvent, bailed out by the government, is assessed a fine or found liable for fraud, or enters into a settlement in lieu of such a fine or judgment. The discussion is thoughtful, engaging, and gives much food for thought to anyone interested in financial regulation.
Of course, as with any creative proposal, Hill & Painter’s concept of covenant banking is bound to raise many questions and objections, some of which the authors correctly anticipate and discuss in the last part of the book. In my view, the more fundamental potential criticism of their book is that their proposed solution seems too narrow, especially in relation to their broadly painted and multi-factored diagnosis of the ethical degradation of the investment banking industry. The story of this gradual loss of Wall Street’s professional ethos, so forcefully presented in the beginning of the book, is at least as much a structural story as it is an attitudinal one. Yet, the contractual personal liability solution has little to say about the broader structural trends in the financial industry. It is possible that expanding the scope of the proposed solutions would have diffused the focus of the book and diluted the force of its core argument. So, the bottom line is simple: this is a great book, and I hope you will read it with interest.
More importantly, I hope that Wall Street CEOs read this book – and soon!