How Incentives Alter the Behavior of Questionable Banks (w/ David Enrich)
ED HARRISON: At some point earlier, we were talking about Wells Fargo, I thought immediately about companies like HSBC, various other operators out there that have been involved in scandals similar to Deutsche Bank. Deutsche is not really the only one, there are others. When you talk about the three challenges that Deutsche have faces, how systemically do you deal with that when there are all these other companies that have similar if not as deep-seated problems? DAVID ENRICH: I would say the thing that distinguishes Deutsche Bank here is that it's not like it's fallen into one or two scandals, it's been at or near the center of just about every major financial scandal in the world in the past 15 years, which is really quite a remarkable feat. How do you change that for an industry? Man, I don't know. The symbolist way to talk about it, but I don't know that this works, is through policymaking at a government level or a central bank level and you cannot fiat a cultural change but you can change or require changes to compensation systems, for example, that would do much more to reward a performance of an overall company or as opposed to individual traders or even a trading desk. For every solution like that, though, there's almost inevitably a million ways to exploit it and find loopholes, not to mention unintended consequences of doing that. We've seen that in the UK with some of the compensation rules that were introduced after the financial crisis there that have led to base salaries have gone way up, and the variable portion of people's pay has gone down. That's not necessarily a good way of doing things either. You can argue that-- and I think in fact, you should argue that there should be higher capital requirements, tougher leverage ratios, and basically should discourage banks from operating as just these risk loving institutions, as long as there is this presumption that governments are going to come bail them out in a crisis, because right now, there is a very asymmetrical risk proposition for a bank. If they refer a bank employee even more important, if employees are getting a cut of what they earn for the bank, and they earn, let's say, their group earns a million dollars, and they're getting $100,000 of that cut. On the other hand, if they lose a million dollars, it's not like they're losing $100,000. They get zero. It's a very lopsided incentive structure that encourages you to shoot for the moon and not be particularly cognizant of the risks. ED HARRISON: It's not like there are any claw backs per se, there's the whole thing. IBG, YBG. I'll be gone, you'll be gone. What has happened? DAVD ENRICH: Yeah, exactly. Well, claw backs have become more prevalent in the industry. I think that's very healthy. Look, I think the industry, by and large, has made important strides since the crisis to reduce risk. It's not because the banks are like acting morally or ethically, it's because they're responding to investor demands and regulatory demands that their behavior change or otherwise people won't invest in them, or they'll make it much harder to operate. look, I think you can round the edges, it's easy for regulators or investors to push for a more conservative and leaner approach to banking. Banking shouldn't be that profitable honestly. ED HARRISON: I was going to say what countries have successfully made the transition? The first country that came to mind for me was Switzerland. Because when we think about Credit Suisse and UBS, they were really at the center of the banking crisis, right downs, out the yin yang, level three assets, topping up their balance sheet in order to yoke to their capital. Now, they're all about wealth management. They're all about simple banking, they're really not about taking risk. DAVID ENRICH: That's partly a response to sky high capital requirements in Switzerland that have led-- they have just shifted the profitability of different business lines and made it so that sales and trading is just it's way too expensive from a capital standpoint, to be worth doing and yet they have, in part because of Swiss Bank Secrecy laws and tax laws have a natural and long standing competitive advantage in the field of wealth management, in part business, Switzerland's legacy of hiding assets for people. Another example would be Iceland, which has went from-- no one really cares about Iceland, because it's Iceland, but it was the epicenter in a lot of ways of the financial crisis and that it went-- this is essentially efficient economy that the economy is financialized. These huge banks rose out of nowhere, and then collapsed because they were built on just in some cases, fraud. Iceland, instead of just increasing regulation of the banks, took things a big step further, which is that they pursued criminal charges against a lot of the bankers at the tops of these institutions, and they succeeded, and these people went to jail. Laws are what they are in different countries, but the act of personally punishing people at the tops of these powerful institutions, that is a deterrent. If a banker is scared, not just about missing out on a bonus or worst-case scenario losing their job, but is instead scared about their reputation being destroyed, or their freedom being taken away from them, that is very strong reason to reduce your risk taking, whether it's cultural risk taking or financial risk taking, or whatever, it provides you a very strong incentive to make sure that not only are you doing, you're operating within the law, but that 10 years later or five years later, looking back in hindsight, and when investors are digging through your emails or your chat messages, that there is not going to be any prosecutor who could even argue that you were violating the law. Really, that would change behavior in a very powerful, I think, pretty rapid way honestly. Now, again, we live in a country and society that has laws and respects the rights of defendants, and as well, we should, but prosecutors in the US in particular have been just very, very reluctant to pursue high profile criminal cases against people in the finance industry. That is I think, part of the reason that there's been such populist anger over the past decade toward the financial and political class in this country, that it seems like a lot of people's lives were ruined by the actions the banks took, and almost no one at the top of those institutions was held legally accountable for that. ED HARRISON: Okay, so let me just play devil's advocate here for a second, with regard to Trump. The question is, if you're a devil's advocate, you would say, actually, Deutsche Bank, as you rightly point out is an institution that's not well known in the United States. They're trying to make business in America and so they take risks there. The controls that are deficient there are only in the United States that had the same thing happened in Frankfurt or London, it just wouldn't have happened that way. DAVID ENRICH: The special thing about Deutsche Bank is that it managed to create these problems all over the world. There's actually a similar situation to Trump that Deutsche Bank had out of its Frankfurt offices. There was a real estate developer in the mid-90s, named Juergen Schneider, who is developing shopping malls and the like, and Deutsche Bank was one of his primary financial enablers. In fact, some of the shopping malls he was opening were literally across the street from Deutsche Bank's headquarters in Frankfurt. Schneider turned out to be a complete fraud and ends up I believe, getting in a lot of trouble for that. Deutsche Bank is caught essentially with his pants down and they had made huge loans that they had very little recourse on. They got wiped out on those loans. This is around the same time they're getting into bed with Donald Trump and the circumstances in the US and Frankfurt are different, but this is clearly an institution that was throwing normal credit underwriting, blocking and tackling skills, throwing it to the wind. Look, it wasn't just in Germany, either. This is the bank was starving for profits all over the world and very hungry for the profits all over the world, I should say and was doing whatever it could to satisfy its ravenous appetite and so you look at a place like Russia where the bank had operated for most of its history. It goes back to the 1800s where it's financing railroads for the Tsar. Deutsche Bank took a lot of pride in Russia at doing whatever it took to satisfy its clients. By the late '90s and early 2000s, through most of that ensuing decade, what its Russian customers wanted, were money laundering or capital flight services to get their often ill-gotten rubles out of Russia into foreign currencies like dollars, or euros. Deutsche Bank's set up a very elaborate money laundering scheme that enabled its Russian oligarch clients and others, including a bunch with direct connections to Vladimir Putin to get their money out illegally. This was, as were many of Deutsche Bank schemas over the years, this is a great business for them. There were very few other banks willing to take that risk, for the obvious reason that it was illegal. Deutsche Bank was minting money on this, and they were doing well over 10 billion dollars of money. They got out of Russia in an appropriate way. They were charging huge fees for the privilege of doing that, and they could because no other bank was willing to do this business. Deutsche Bank, in this relentless pursuit of profits all over the world, stumbles. Stumbles isn't really the right word. They go pretty deliberately, across the line over and over and over again and the result in the short term is that it's extremely lucrative. The result in the long term is that they face massive government penalties, in some cases, criminal prosecutions, and the reputation gets annihilated.