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How to Fairly Punish Bad Banks

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Let me start with some facts, often shunned in first paragraphs, but required here. UBS (NYSE: UBS  ) is on the verge of paying a $450 million -- possibly much more -- fine for rigging LIBOR. Citi (NYSE: C  ) is being investigated for the same thing, but in a bigger way. Barclays (NYSE: BCS  ) took a $450 million hit earlier in the year for LIBOR-related charges. HSBC (NYSE: HSBC  ) is $1.5 billion in the hole for money laundering, this year. Assuming Citi ends up being in a common boat with Barclays and UBS, that's about $3 billion in fines, in one year, between those four banks.

Investors have had just about enough, and the stocks have been hammered this ye-- What's that? Oh, I see. UBS is up over 45% this year, Citi is up close to 40%, Barclays up almost 60%, and HSBC is dragging the pack down, up only 35% or so.

Well, hell.

Almost everything about this article is depressing
Let's talk about being bad first. Why are banks -- or anyone who premeditates a crime -- doing bad things? Put simply, it makes sense to be bad. Take the value of being good, and say that if the bank does what it's supposed to do, it makes $X. If it does something bad, it makes $(X +Y). But if it does something bad, there's a chance it's going to get caught, C%, and pay a fine $Z. So then it just weighs the whole thing up and if $(X + Y)-(C% * $Z) is greater than $X, it makes sense to be bad. Sometimes, the punishment isn't even as much as the extra money made, so you might as well go ahead and do it.

Good start. We can see why banks are cheating. Now, why are investors putting up with it? There are three things that investors like about banks, especially in this economic environment. First, banks make a lot of money, even when they get fined. Citi put up $468 million last quarter, and analysts are estimating that the bank will continue to grow at 10% over the next five years.

Investors also like that banks seem to be undervalued. Just a simple Google search for "undervalued bank stocks" returns hundreds of recent articles, many of which focus on the "if everyone is scared, now is the perfect time to buy" mentality. As an added bonus, banks have absolutely huge amounts of capital, making them virtually indestructible.

Which segues to the third great reason to buy banks: governments. This is pure conjecture, but I think you can buy JPMorgan Chase (NYSE: JPM  ) , and never lose a night's sleep. Because it's one of two clearing banks in the U.S. that can handle tri-party repos, CEO Jamie Dimon could probably call every customer individually, threatening to kidnap their pets unless they forked over 90% of their personal savings, and the bank wouldn't be hurt. Too big to fail is like magic, free insurance.

A plan is devised
Going back to the original problem, banks seem to be able to get away with murder -- or the financing of -- while booking huge sums of income and appreciating in value. The fines being levied are too small, and there are no good oversights in place, since the banks are policing themselves. We've already seemingly given up on breaking up banks, and we can't fine them too much because you don't want to actually put them out of business, just teach them a meaningful lesson.

When we punish people, we take away a meaningful amount of money -- or we take their time, and I think that's the solution to the problem with banks. Regulation is the one thing I have ever seen Dimon rail against, because regulation slows things down. In fact, that's the goal of lots of regulation, to slow everything down and take a close look at what's actually happening. Earlier this year, Dimon said, "I have this great fear that someone's going to write a book in 10 or 20 years, and the book is going to talk about all the things that we did in the middle of a crisis that actually slowed down recovery."

His focus in that speech was on job creation, which comes through lending, which means more profit for banks. Slowing down lending slows down profit and, Dimon thinks, job creation. But that's only true if it's universal, if every bank stops lending and credit simply isn't available. But if a few banks are lending easily, and a few are in tough times, then credit is still available. So, what if we did three things?

Problem solved
First, we increase how much we fine banks for messing around. That's simple. It doesn't have to be ridiculous, just meaningful. HSBC shrugged off the $800 million is set aside last quarter, so make them pay twice as much. It's not a company killer, but it hurts a bit.

Second, we're going to have step increases in capital requirements for banks that break the law. The rules are there to manage risk, and to ensure a level playing field. If you can't abide by the rules, then you're a bigger risk to the economy and the population. Being too big to fail might not "cost" anything, but if you abuse the right, then increased capital requirements can make you pay. Bump it up each major violation, based on the size of the risk incurred.

Finally, put banks in timeout. Investors want growth, and regulation slows growth. That's how you take the bank's time as punishment -- with a series of strict oversight regulations that only apply to banks that break the law. The bank moves slower under the regulatory environment, so investors have a reason to stop rewarding bad behavior. It also acts as a real deterrent to crime, since the people who have the most to lose with stock price drops are the people at the top.

And there you have it, three simple steps to making the banking world better, safer, and fairer.

Read/Post Comments (7) | Recommend This Article (16)

Comments from our Foolish Readers

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  • Report this Comment On December 06, 2012, at 7:56 PM, TMFCatoMinor wrote:

    Great article, and a very reasonable approach. Far more reasonable than mine. Call me a radical, but personally I have a bit of a problem punishing a corporation's stockholders, employees, customers, and clients for the CRIMINAL actions of individuals. Leave the corporation alone, put the criminal actors responsible, including and especially the management team, in prison. To quote Spiderman, with great power comes great responsibility. You take home an eight figure income and lead a major global corporation? You'd better be especially careful not to break the law.

  • Report this Comment On December 06, 2012, at 8:15 PM, XMFRedRam wrote:

    I agree, to an extent. Due to the rampant nature of the problems, I think it's clear that there is a cultural shift that needs to take place. If it's an entire culture that's broken, then I think the punishment needs to be more far reaching.

  • Report this Comment On December 11, 2012, at 10:46 AM, Tomohawk52 wrote:

    If you aren't going to jail the major players at least take ALL of their money away. You hit them where it hurts. When Jamie Dimon is panhandling on the streets for dimes then the problem will magically solve itself PDQ.

  • Report this Comment On December 11, 2012, at 11:15 AM, damilkman wrote:

    This is one of the best reads on Fool ever in my opinion. The proposal is reasonable and I believe doable. Individuals would be indirectly punished because regulators could equate "RISK" with who is in charge. For example if Mr X and his team are in charge and break the rules, the regulating bodies can inform the board and the share holders that increased regulation and strictor leverage requirements will have to be in place because Mr X is there. Of course if the environment is changed by bringing in a new team that has a positive reputation the requirements might be loosened faster.

    The interesting item is if Mr X is forced out, can that albatrose be kept around his neck if he leaves for another bank? In college basketball crooked coaches can destroy programs and there is no negative impact when they move to another school. Can a regulatory body go to a board and tell a board? Well, we see that you now have Mr X, My Y, and Miss Z who have all been on our bad side in the past. If individuals are unable to move out from their dastardly deeds, that might also prevent them from considering being bad as it could mean end of career.

  • Report this Comment On December 11, 2012, at 12:18 PM, BMFPitt wrote:

    If criminal laws are broken, people need to go to jail. Period.

    At the corporate level, proceeds from a crime should be confiscated and distributed to any victims, if applicable, or to a fund that pays down the national debt.

    The agencies responsible for investigation and determining any fines must not in any way benefit from the proceeds of these fines.

  • Report this Comment On December 11, 2012, at 12:22 PM, atkinskd wrote:

    Well put. Rather than prison time I would suggest agents caught in these acts be barred from financial career opportunities for life. Prison is far to easy, having to eek out a living from within the predatory parasitic environment they created is much more suiting - after their entire net worth has been liquidated of course.

  • Report this Comment On December 11, 2012, at 1:31 PM, whyaduck1128 wrote:

    damilkman--The NCAA has what's known as a "show cause" order with respect to rogue coaches. If you're a school that wants to hire one of these bad apples within the NCAA-specified time period, you have to "show cause" to the NCAA that all measures are in place to insure that the individual has no opportunity to break the rules again. To my knowledge, no one has ever tried to "show cause", because the feeling is that the NCAA will never grant one.

    It would work for the financial services industry. Imagine if you will a senior VP in a major bank, under a "show cause" order for 10 years. The only situation in which I can imagine this not working is for people near retirement age.

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