You're assuming that the occasional gigantic bankruptcy isn't a natural outcome of the smartest strategy as a bank. But when you're comped on this year's profits, and a large chunk of your comp is cash, it makes sense to take huge risks that result in near-term profit, or immense long-term profit, and largely ignore the potential for a total collapse. (Not to mention most of the employees found jobs at other banks, or even just stayed at Barclays after the bankruptcy.)

If you're making $1M-$10M a year, the downside to a 5% or 10% chance of your employer going bankrupt is not so large that you're going to reduce your income to prevent that. And if you are, they'll just replace you with someone who is less "risk averse."

You bring up a great point, which is actually an excellent alternative answer to OP's question, "what do you expect?"

What we should expect is for banks to protect themselves as businesses by changing compensation to account for long term risk. And if they fail to do that organically, we should acknowledge that the market is failing in a dangerous way and more regulation around compensation is needed.

I don't know that you need to regulate compensation. You just need to not bail them out when they blow up, and it will self-correct. And you shouldn't let them gamble with federally insured (FDIC) money - either be a investment bank or a commercial bank, but not both, so that regular consumers don't get caught in the middle.

I totally agree. Had everyone been allowed to fail, we would've been well on the way to recovery already. It's frustrating to watch the government keep this pathetic lifeline going which will fail in the end anyway.

But isn’t this scenario impractical for reasons shown by the current problems in Europe? On Cyprus, the banks were considered “too big to fail”, meaning that they would take the whole economy with them if they went down.

Cyprus is not a good case study - the banks there actually are the whole economy, to some degree. Aside from tourism, they were supporting themselves by banking a lot the money coming of Russia, etc. The assets of Cypriot banks were ~9X their GDP, and the size of the estimated bailout was about 1X GDP.

If you don't let big banks fail, then nobody ever has to worry about counterparty risk, and they won't keep an eye on each other to see if one bank is taking too much risk or backing too many bets.

This is known as a partnership, where the partners' personal assets are at risk. This is what the investment banks used to be, way back when. (Consulting firms too, for that matter)

If I had some sort of magical power to enact this kind of reversal to where ibanks were once again partnerships, I'd do it in a heartbeat.

Ironically for the great-grandparent post, both the grandparent and parent post are "both completely true" as well.

We quite correctly should expect governments to (have) ensured that these corporations could be allowed to collapse, indeed they (bravely) did with Lehman, just AIG was worse.

We also should expect that if you give someone 10-40 years salary each year, then that bonus really really should be well aligned with the stockholders own goals, or they will act in their own best interest (correctly).

The only thing that turned a disaster into a once in a century clusterfk was being unable to let them collapse.

So thats surely the public policy takeaway here.

I could swear I'd read somewhere a couple years ago that a lot of the TARP money - especially from smaller banks - was repaid by them refinancing into SBA loans. So, yes, technically TARP funds were repaid, but often by borrowing from some other govt program at a lower rate.

I might refinance my house to a lower rate, but I would be lying if I said I "paid off" my house. I paid back one lender by borrowing from another, that's all.

But... I can't find the info I thought I had bookmarked some time ago outlining if/when this happened.

EDIT: http://online.wsj.com/article/SB1000142405297020413820457660...

"More than half of $4 billion in federal funds disbursed this year to spur small-business lending by community banks was used to repay bailout funds that the banks received under the government's Troubled Asset Relief Program.

The Small Business Lending Fund was meant to raise capital at smaller banks, which tend to lend more heavily to small businesses, in the hopes of jump-starting growth and employment. But instead of directly lending to small businesses, many of the banks used the money to rid themselves of higher-cost TARP debt and tougher restrictions."

That's obnoxious, but it is less than 1% of TARP funds, right?

That 4 billion was just for one year, AFAIK. I don't think this particular sleight of hand was used on a large portion of TARP money, but I also have a hunch there were other ways that TARP money was 'paid back' while still leaving tax payers holding some of the bag still.

>Lehman was emphatically NOT staffed by the best and brightest -- it collapsed.

"Lehman collapsing" might be unrelated to "individuals at Lehman succeeding". You make a big gamble and if you succeed, there is big bonus. If you lose, there are no financial penalties (at worst, you lose your job which should not be a big deal for someone who has already made millions. Like, Dick Fuld). In fact, in absence of regulations like bonus clawback or multi-year bonus vesting, folks on Wall St. seem to have behaved in a completely rational way until 2008 crash.

Ding ding ding.

"moral hazard" / "agency problem"

If we let the banks go down should we have let the counter parties go down as well? Should AIG have gone down? While I agree that it would have been better in the long run to let them fail there would have been tremendous consequences to doing so in the short term.

If a public pension fund went down with it should it have gotten tax payer money? How about GE? Was the intervention in the short term commercial paper market appropriate? Incidentally this is the one intervention that I still feel was absolutely necessary.

While I can hate on the banks as much as the next person there would have been real consequences to letting them fail and I don't think that most people would have gone along with it. If JP Morgan had fallen into bankruptcy and companies (regular ones) that bank there had been unable to make payroll since there cash (and cash convertibles) were frozen there would have been chaos.

This started with small interventions like the latin american debt crisis and now that the genie is out of the bottle its not going back in.

Exactly. Not disagreeing with the OP, but in it's purest sense "free marke"t assumes that these more sophisticated ones have just as much to lose as the unsophisticated (and therefore bear the same risk). This is the problem when you try to mix regulation with deregulation.