Executives at Silicon Valley Bank (SVB) and Credit Suisse took substantial risks. SVB proactively expanded the bank’s deposits, some might say excessively. These depositors were uninsured and undiversified. And back when interest rates were low, the bank invested significantly in US government bonds, which was fine at the time. But when there were signs that interest rates were rising and creating substantial interest rate risk, managers left this portfolio unhedged and unchanged. How come SVB managers took those risks? It seemed that they lacked “skin in the game”.
The risks taken by executives at Credit Suisse were of a different nature, but still substantial. By becoming involved in such companies as the now defunct Greensill and Archegos, the bank’s capital took a hit. The fines it has accrued after facing scandal after scandal have also bitten into its capital. It can be said that those involved also lacked skin in the game.
In the aftermath of the 2008 financial crisis, there have been efforts on both sides of the Atlantic to ensure that future bailouts of depositors would involve as little taxpayer money as possible, and would penalise bank owners. The Dodd-Frank Act in the US, for example, seemed to promise that, should a bailout of depositors be needed, shareholders would take the hit. If a bank needed to be closed and restructured, shareholders would bear losses and some creditors’ bonds would be converted into stock, which could lead to substantial future losses. Regulations in the UK and the eurozone went in similar directions.
These were extremely welcome efforts. Differentiating depositors (who can know almost nothing about a bank’s operations) and bank owners (who should in theory know and monitor things a lot more) makes a lot of sense. The problem is that despite this new rulebook, significant cracks remain, meaning bank executives can still get out unscathed – and will continue to take risks that threaten the stability of the entire financial system.
Let’s take the SVB example. After its failure, depositors were bailed out, and shareholders made to take losses. So far, so good. Except that some executives at the very top bore almost no losses at all – in fact, they made a profit. They sold their shares two weeks before failure, when there was no public information yet about the state of SVB, so its shares were still high. The problem is that they did this perfectly legally. Here’s how.
Financial regulators have long recognised the potential for such behaviour, and have rules against what is called insider trading – the sale (or purchase) of shares motivated by internal information that is not known to the public yet. There is a sense in which executives always have more information than the public, but surely one can’t bar them from selling their shares at all times? Therefore a law was passed that said an executive could file a plan to sell their shares one month in the future, since public information can change and share prices fall.
The executives filed exactly such a plan; and yet a month afterwards, the public still didn’t know about SVB’s difficulties – so share prices were still high and executives reaped a profit. There is therefore a discrepancy between what the law is trying to achieve and what it does achieve. A law has just been passed to increase the waiting period to three months – but is that really going to change the game? In this particular case, it would have; but in others it may not. One would guess that these executives made a prediction that they would not be penalised, so they took these risks without much skin in the game.
This calls for a fundamental rethink of shareholder liability rules. If executives want to decide exactly when to sell their shares – let them. But let’s make sure they remain liable for any losses at the bank for at least one year. That way, executives remain free to sell, but remain liable for the bank’s difficulties for a long time after.
Skin in the game is absolutely key to averting financial crises.
Natacha Postel-Vinay is assistant professor of economic history at the London School of Economics
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