Covenant Banking

A new book out by University of Minnesota Law Professors Claire Hill and Richard Painter proposes a really intriguing proposal for disciplining wayward financial services firms: "covenant banking." The problem, as Hill and Painter observe, is that when things go badly at a financial institution, the burden is borne by shareholders, not by the managers, who have portable human capital and whose compensation is not typically subject to clawback. In essence the problem, as Hill and Painter see it, is that bankers lack "skin in the game."  

Historically, this was not the case. Historically, banks were organized as general partnerships, meaning that there was unlimited personal liability for all the partners. Moreover, historically there was much less ability for bankers to move between firms and the taint of scandal was more severe. In other words, bankers weren't just playing with other people's money. They were putting their own livelihoods and fortunes at stake.

There has been a strain of post-financial crisis writing urging reforms of executive compensation in financial services. Hill and Painter make an important contribution to this literature by arguing that these reforms do not require legislative action—a virtual guaranty of nothing happening in our dysfunctional republic. Instead, Hill and Painter argue, convincingly, that reforms can be enacted contractually through what they term "covenant banking," in which financial services executives essentially pledge to act as guarantors for their own firms up to some level. The book discusses various forms in which this could happen, but the details aren't critical to understanding the idea: Competition for investment will result in bankers putting more and more of their own skin in the game and thus market discipline will be restored to banking. (The book also intriguingly suggests that the federal government could encourage covenant banking in numerous ways not requiring legislation, such as in the terms of deferred prosecution agreements or by favoring banks with covenant banking compensation in Treasury security auctions.) 

I really like this idea, and think that it will get some real traction in the public policy space. I could very easily see some Presidential candidates endorsing the idea.

That said, I find myself wondering why it hasn't happened already if it is simply a matter of contract, and why banks were able to get away from partnership structures in the first place without competitive cost. The first question is the classic law-and-economics tautology of perfect markets. The answer might simply be path dependence. It might also have something to do with the nature of institutional investment markets, which entail lots of complex relationships and conflicts.  Regarding the second, the book tells an interesting tale of the devolution of banks from partnerships to publicly traded corporations. It took a while after the change for scandal to become commonplace, so there was no penalty for the shift when it happened because no one associated it with problematic outcomes.

Bottom line:  the idea of covenant banking is one that deserves to get some serious consideration in policy circles.  Read the book.