Moral Hazard in Banking

Published on May 1, 2023

“I would suggest that anybody that’s CEO of a bank that screws up and cost shareholders a lotta money that in effect, you know, they get no pension from the bank. They go back to living, you know, like a person that works on the production line of Ford or something like that. They don’t deserve anything special. And I would suggest to the directors of the bank that sat there for five years and listened to people come in and give reports and all that sort of thing, that they give back all their director’s fees.”

— Warren Buffett, April 12, 2023

First Republic’s Failure

The Federal Deposit Insurance Corporation seized First Republic Bank this morning and sold most of the bank’s operations to JPMorgan Chase. The final sentence in the FDIC’s press release states that the estimated cost to the deposit insurance fund will be ~$13 billion. No depositor, whether below or above the FDIC’s $250,000 insurance limit, will suffer a loss of funds since JPMorgan will take over all deposits.

The standard practice is for the FDIC to recover losses to the deposit insurance fund by raising assessments on healthy banks. Ultimately, banks will either pass on these added costs to customers or shareholders will take the hit. In either case, the consequences of the mismanagement of First Republic will fall on individuals and institutions that had no role in the bank’s failure. 

JPMorgan Chase issued a press release stating that the substantial majority of First Republic’s assets were acquired including ~$173 billion of loans and $30 billion of securities. JPMorgan will assume ~$92 billion of deposits including the $30 billion of deposits that eleven large banks deposited in First Republic in mid-March in an attempt to save the bank. JPMorgan owns $5 billion of those deposits, which will be eliminated in consolidation, and will repay the other $25 billion in the near future.

The potential losses for the FDIC are not limited to $13 billion. The FDIC is providing loss sharing agreements covering single-family residential mortgage loans and commercial loans. JPMorgan’s investor presentation indicates that this agreement provides 80% loss coverage for both categories of loans for seven years. In addition, the FDIC will provide JPMorgan with $50 billion of five year fixed-rate financing. 

JPMorgan will recognize a one-time, post-tax gain of $2.6 billion which will be partially offset by $2.0 billion of post-tax restructuring costs it anticipates incurring over the next eighteen months. The transaction is accretive to tangible book value per share and estimated to provide $500 million of incremental annual net income.

This all sounds like a sweet deal for JPMorgan and another feather in the cap of Jamie Dimon, the bank’s longtime CEO. Mr. Market seems to like the deal with JPMorgan stock up over 3% in morning trading. Although JPMorgan states that this is all the result of a competitive bidding process that minimizes losses to the FDIC, the only other bank rumored to have submitted a bid over the weekend was PNC Financial Services. The other banks large enough to submit a bid, all of which are considered “systemically important”, apparently declined to even enter into the competition.

On the losing side are the holders of First Republic’s corporate debt, preferred stock, and common stock. The market for the common stock was halted and the stock is likely worthless. It is doubtful that much of a recovery will occur for senior securities. 

JPMorgan’s investor presentation highlights First Republic’s affluent client base and geographic advantages and there’s no doubt that Jamie Dimon will try to retain key talent. However, top management of First Republic will clearly be out of a job and directors of the company are no longer needed. But don’t shed too many tears for these select few individuals who are losing their jobs or comfortable sinecures. As I pointed out in March after reviewing First Republic’s proxy statement, all of these individuals are going to be just fine financially — and that is an understatement.

It is obscene to watch the executives who ran a financial institution into the ground emerge from such a fiasco with net worths that can secure a lifetime of leisure and, in some cases, even multi-generational wealth. Defenders of top executives point to the fact that most had compensation tied to the bank’s equity which is now worthless. However, this downplays generous cash compensation bank officials received over many years, both from direct cash payments as well as the proceeds of stock sales. 

There is a profoundly troubling asymmetry at work in which complete and total failure does not result in anything resembling commensurate hardship for the top people responsible for the situation.

Buffett’s Proposal

Warren Buffett’s appearance on CNBC on April 12 included several lengthy statements on the banking crisis and what should be done about the moral hazard problem in banking when market participants believe that essentially all deposits will be backstopped by the FDIC. 

Mr. Buffett was very forceful in his assertion that no depositor in the banking system will lose any funds, whether above or below the FDIC’s limit of $250,000. He even offered to make a bet of $1 million that no depositor in a U.S. bank will lose money over the next year, with the proceeds of the bet going to charity. I’m not sure if anyone was brave enough to take him up on the offer.

In my opinion, there’s an important role for uninsured depositors to play in keeping the banking system in check and controlling moral hazard. Small depositors clearly have no capability to monitor banks and role of deposit insurance has traditionally been to protect such individuals and small businesses while maintaining a level of risk for larger (and presumably more sophisticated) depositors in order to encourage monitoring of the banking system by private parties.

In a system with unlimited deposit insurance, whether this is done formally or is due to widespread belief that the $250,000 limit is actually unlimited in practice, depositors will have no incentive to police the system. Moral hazard will have to be countered by those who own securities in the bank and by regulators. 

It is apparent that regulators have not been up to the job, something that even the Federal Reserve seems to now grudgingly admit was the case with Silicon Valley Bank’s failure. Owners of a bank’s equity and debt can and should be expected to monitor the situation, but anyone who has read a bank’s financials from an outside perspective knows that many aspects of a bank are inherently non-transparent. 

The difficulty of directly monitoring risk is why shareholders elect boards to monitor management. However, boards do not seem to be up to the job either. Board members face an asymmetric situation: if all goes well, they can collect an easy quarter million dollars per year (higher in many cases), but if it goes to pot, they just walk away from the situation. Even in cases of malfeasance, nearly all companies provide directors and officer insurance that limits personal liability. There is usually no skin in the game.

provided my thoughts on First Republic’s compensation, as disclosed in its latest proxy, in another article in mid-March so I will not repeat the specific criticism here. Instead, let’s consider how Warren Buffett’s proposal, quoted at the beginning of this article, might be put into practice:

  • Directors should forfeit five years of compensation. I suggest that we define compensation as the after-tax cash proceeds that the director has received over five years whether paid in cash or by liquidating stock-based compensation. All remaining equity holdings, if they have any value, would be forfeited. I recently went through the exercise of estimating Barney Frank’s cash proceeds from his directorship at Signature Bank and the same could be done for other directors.
  • Named executive officers should forfeit five years of compensation less $100,000 per year. We could define compensation using the same methodology as for directors: the after-tax cash proceeds that the executive has received over five years, whether paid in cash or by liquidating stock-based compensation. From this amount, the executive would keep $100,000 per year and forfeit the rest.
  • All proceeds from Director and Officer insurance policies would be forfeited. If the company provides D&O coverage, the proceeds would be forfeited in the event that the FDIC seizes the bank. 
  • Clawbacks would apply to retired directors and officers. All retirees, or their estates, would be subject to the provisions listed above for five years. 

The intent would be for all of these provisions to reimburse the FDIC deposit insurance fund in the event of a bank failure in which the fund suffers losses. This type of reform would certainly focus the attention of directors and executive officers since they would suffer significant financial harm if the bank fails. 

The point is not to make much of a dent in replenishing the insurance fund but to reduce moral hazard in the system. This plan is substantially more generous than Mr. Buffett’s proposal since executive officers are allowed to keep $100,000 of their compensation per year, far more than a typical auto industry assembly line worker will earn on an after-tax basis. No one is going to miss any meals.

Will these reforms occur? It seems very doubtful … 

But something along these lines should happen, especially if we are entering an era where everyone believes that deposit insurance is effectively unlimited. Moral hazard, already a major problem, will become even worse without serious countermeasures.

There is very limited political appetite for reckoning with the obvious weakness in banking regulation. In this case, the “too big to fail” problem has just become even bigger as JPMorgan expands its operations. Jamie Dimon walks on water when it comes to the mainstream financial media, but that verdict is hardly unanimous. We should also keep in mind that Mr. Dimon is sixty-seven years old, has experienced several very serious health problems, and will not run JPMorgan forever.

An old superstition says that “back luck comes in threes.” The FDIC insurance fund has now taken substantial hits from three bank failures in 2023 and the year is still relatively young. As the Federal Reserve continues to raise interest rates and the tide goes out even further, more naked swimmers will emerge. I doubt we have seen the last of the chaos in banking this year.

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Moral Hazard in Banking