Transactions: April 25, 2011

What is a bank? We used to know. In days of yore, banks were easily defined and recognized as banks: columns, marble, vaults, tellers with toasters, brown-suited bankers with putters. Wells Fargo and Bank of America were banks; Goldman, Sachs & Co. and Morgan Stanley were not. The latter gold-dust twins were investment banks, wholesale banks, white-shoe banks, merchant banks, broker-dealers, and thus sequestered by legislation from the unwashed proletariat. Of course, that was before the world grew fatter, faster, richer, more global, more networked, more performance oriented and, in America, more unequal. Commercial and investment banking converged into a fermenting mass called Banking. And when nearly everything became a bank, when nearly every money product found a home in a bank, the once sharp outline of Banking blurred until it merged with the activity known as Finance. Today that's just one part of our problem. Big banks are too big, too complicated, too incestuous. Their capacity to change, grow and evade regulation resembles an alien life form. Their appetite for risk is gargantuan. They are scary marvels. Can't live with 'em, can't live without 'em.

The debate over big banks occurs under different guises. The political rump wrings its hands over Wall Street, its philistines, plutocrats, greedheads, oligarchic powers and pay packages. This debate is mostly conducted through insults; its underlying drive is envy; its subtext inequality. From the regulatory camp, the argument, like those that swirl around nuclear safety, orbits the word containment. This debate produces volleys of jargon; its underlying fuel is fear; its subtext, growth. The Brits recently published a report on what to do about the banks from a group led by former Bank of England chief economist Sir John Vickers. Some expected them to propose radical surgery; instead they put out a deceptively comfortable-shoe report that ring-fences retail banks and refreshingly acknowledges minor tradeoffs like growth versus safety. The report has triggered agita, probably a good sign.

Still, even Vickers may underestimate the tangled nest of big-bank incentives. Banks operate in multiple dimensions rife with every-which-way incentives. Paradox often trumps alignment. Martin Jacomb, former chairman of the U.K.'s Prudential plc, fingers one such paradox when he argued in the Financial Times that the more onerous the rules to limit risk, the likelier managers will indulge in it. Rigid rules may shift responsibility from managers to regulators, who, given the complexity of everything, inevitably play catch-up. You can take that further: Too many rules mean no single rule counts for much. Moreover, banks suffer from serving two masters: regulators and shareholders. (Often enough, given their lobbying clout, there's a third lurking: Congress. And a fourth, bankers themselves.) We expect interests of multiple masters to be hammered into alignment; in reality, they're often at odds. And the salient fact of banking evolution since the '70s is that ownership, particularly on Wall Street, has grown more public, and that institutional shareholders, dragging large portfolios, have developed a hunger for risk.

Skepticism should prevail about any incentive "rule" that derives from economists' penchant for distilling behavior from utility functions. The psychology is fodder for witch doctors. In real life, management behavior, hostage to personality, culture, history or sunspots, eludes prediction. The fact that banks have been collapsing since Pericles suggests there's no structural panacea. Despite nostalgia for restoring partnerships (safe! small!), their record is spotty as a dalmatian. Consider the Baring Brothers partnership in London, which triggered the Panic of 1890 and had to be rescued, only to succumb in 1995. While unlimited liability partnerships might restrain size and risk taking, they also stifle liquidity and growth. And to extoll partnerships, with their direct link between ownership and management, is to acknowledge the flaws of shareholder governance. Moreover, we're ambivalent whether it's better to offer more "product" to investors by broadening public ownership or whether we favor risk control and inequality through private ownership. As for rigid oversight of banks as a solution -- well, again, what's a bank anyhow? Barriers between commercial and investment banks first gave way in the '80s when regulated banks lost business to loosely regulated nonbanks. Partial regulation encourages disintermediation, which spawns either overeaching reregulation or underreaching deregulation. The real problem is that we expect banks to be all things -- efficient, smart, safe, stimulative, public, pals of the proletariat, tools of foreign policy, purveyors of toasters -- and all things financial to be banks. Our expectations overwhelm our good sense.