Mr. Johnson - I could not agree with you more. However, I do not think a picture of the Treasury Secretary with a Hitler mustache is appropriate. Unless that is a shadow- but it certainly could be mistaken for a mustache.

Sorry, but this is just silly.  Banks will set up separate corporations for each targeted area. If those financial institutions go mahooly, the loss will be limited. It is up to the world's and each country's regulatory agencies, to make sure they don't commit fraud.

Unfortunately, the examples you kindly provided which clearly show what and how wrong things can go in the financial industry will largely be completely ignored for a large variety of reasons. And the financial industries will plunge ahead.  What is most interesting about this piece however is that it demonstrates how much more interested Geithner is about the survival of America's financial institutions than about putting in place the necessary regulations and controls that would in fact benefits Americans.  Good examples of a more heavily regulated financial environment (which even has strong labor unions and a strong manufacturing base) is Germany.  But my guess is they too will be ignored as an example of what to do right because they have a controlled economy.  Thanks again. 

Let me get this straight. American economy is tanking. Bernanke lowers the interest rate to pt25 percent so he can lower the cost of money to the banks. The previous US Treasurer pleads for $700 Billion dollars to save the financial institutions that caused a near depression. States across America are in dire straights because the tax base is decimated. Oh forgot the interest rates for senior citizens is now about 1% thus decimating the value of the inheritance for their children - THE BABY BOOMERS - who are now being targeted to lower their social security income by raising the age to recieve social security. Wait there is more. Take money form the seniors and their children and give it to people like this fraud Treasurer Geithner who is still in diapers and then ask for patience while the Banks, unregulated , start their run again. This has to be a bad fairly tale. Where should I keep my money now? Oh hello I'll just send it to Bernanke since he is going to get it one way or another. Middle Class my ---.

Oh by the way. Ron Paul has been seen with a crow bar trying to pry the eagle off of the Federal Reserve building. Thank You Mr. Johnson. Bravo.

Planetjeffy- the presumption that the loss would be limited simply by virtue of the fact that it is a separate corporation in a targeted area is, well, silly.  And your statement about being up to each regulatory agency to prevent fraud in a world where fraud via banking corporations is the de facto way of doing business shows either: 1) you are naive or 2) you are shilling for the banks.

This is going to seem like a nit-pick, but, given the importance of banker compensation in Mr. Johnson's world view, you'd think his language would be precise in that matter:

"...as executives and traders are paid based on their “return on equity.”..."

except that, of course, they aren't. Bank compensation is traditionally thought of as based on a percentage of revenues. This makes rough sense, since the predominant cost to a bank is compensation, so that revenue is roughly what the employees brought in, and they get to "eat what they kill", while crop-sharing with the bank's equity holders as rent for the franchise and the equity needed to support those revenues. Traditionally the fraction of revenues has been thought of as 50%, although the recent turmoil put stress on that rule of thumb, with, for example, Morgan Stanley paying in the 60s, and the evil Goldman, Sachs being pushed down into the 30s as a concession to the vox populi.

Now, it is true that there is the possibility that the equity holders will seek to renegotiate that deal if they are required to put in substantially more equity, but how that renegotiation will get resolved is unclear at this point. What is the relative value of franchise and equity? Only the second is being degraded significantly if capital requirements change. There also seems to be some room for flexibility on the part of the equity holders...price-to-book mostly averages substantially above 1 over time for large banks.

So, while RoE is not irrelevant to banker compensation, the quote I excerpted above is closer to being false than true.

They ravaged the wealth of the middle class at home and now the want to ravage the wealth of the middle class abroad. 

Secretary Geithner also expects that American banks will resume the leadership and enjoy the trust of the world's financial community.  For the very reasons outlined in your article, this is unlikely given that they must now contend with bigger, competing, foreign banks that are more carefully regulated and better capitalized.  A leap of faith indeed!

Simon Johnson @“Higher leverage increases their payoffs when times are good – as executives and traders are paid based on their “return on equity.”

I am glad Simon Johnson has finally understood the role of leverage… but having done so the logical answer would be to ask the banks to have at least an adequate capital base when doing operations in those foreign places… as an  absolute minimum that would be the same as they are required to have when lending to their local small businesses and entrepreneurs.

@Per Kurowski

To first approximation, bankers are paid on revenues, not RoE. Revenues are largely unaffected by leverage. See my comment above.

@Marke: “bankers are paid on revenues, not RoE. Revenues are largely unaffected by leverage”

Not so. If a bank can leverage 1 million dollars of its equity 12 to 1 then it will be able to generate revenues on 12 millions of operations but, if it is allowed to leverage 60 to 1, then it will be able to generate revenues from 60 millions of operations… that’s how leverage, and bank profits, and bank bonuses, and too-big-to-fail banks, are related.

@Per Kurowski

"Not so. If a bank can leverage 1 million dollars of its equity 12 to 1 then it will be able to generate revenues on 12 millions of operations but, if it is allowed to leverage 60 to 1, then it will be able to generate revenues from 60 millions of operations…"

We are both oversimplifying. You assume that the availability equity capital is the dominant limiting factor in the operation of banks, and that changing the leverage requirement leaves the total quantity of equity unchanged and margins little changed, so that the total amount of business transacted and revenue generated fall by roughly the same factor as leverage.

On the other hand, if business is instead limited by the overall demand, then the equity deployed expands or contracts with the permitted leverage, and revenues are determined by demand and margins.

So consider an alternate (simplified) set of assumptions; if leverage is reduced by a factor of, say, three, then I'd argue that the following is a plausible scenario. I'll assume a broker-dealer like the traditional investment banks, rather than a lending institution:

The broker/dealers raise roughly three times as much equity capital, so that they can support the same level of business. If we start in the high leverage regime with 50% of revenues going to equity and 50% to compensation, then a doubling of margins after raising the extra equity can leave both RoE and compensation roughly unchanged. The increase in margins presumably suppresses demand somewhat, but if margins were tight to begin with (as they largely are), the decline in demand would be small. Revenues are roughly double what they were before the increase in equity, and compensation as a percentage of revenue is now only 25% (that's where I oversimplified in my earlier post). I would argue that margins are largely determined by competition between financial institutions, so their adjustment in the face of dramatically different capital requirements is plausible.

As I look over this post, I realize that some will have trouble with the concept of "demand" for a financial institution. The function of broker/dealers is not primarily to speculate for their own account, but to harvest margins by acting as financial intermediaries between end users who have need for capital or risk transfer. Those who do not understand this point will obviously have trouble understanding this post.

The number of cars sold depends largely on the demand for autos at the cost of production, and only weakly on the leverage of the manufacturers' capital structures. I'm arguing it's not so different for broker/dealers.

Incidentally, in the above post I am giving zero credit to Modigliani-Miller, who would poresumably argue that the lower risk of a less levered broker/dealer should lead to correspondingly lower returns on equity. This line of argument would suggest that margins should not change, compensation should not change and excess RoE is roughly proportional to leverage...closer in spirit to my original post.

I suspect that reality lies somewhere in the middle between these two models.

But the worst part is that regulators instead of acting like regulators acted like risk-managers, when assigning the risk-weights which determined the capital requirements for banks based on perceived risks. That altered Ground Zero and made it almost impossible for banks to perform their capital allocation role.

I do not believe that financial firms alone can cause enormous harm but I do strongly believe that with the help of government and the nonsense bail-outs, they can destroy the world.

But, remember, the sole culprit is goverment who is protecting its allies at Wall Street or other financial firms, and not the financial industry per se which is causing all the trouble.

The following is why this is so:

As known by the Austrians and libertarians, if the internatonal banking and lending business is free of any government control whatsoever, financial firms will lend at their own risks, and without any potential bailouts, they will be well capitalized and lend prudently across borders, because they are not protected by government and because they are competing with other lenders from across the world, not just any small lenders in their home countries.

In any case of crisis in the developing world, the root cause is the inherent bail-outs of the creditors, not the debtors, if you look deeper.

Therefore, it is government and the way the reps are financed, is the root cause of financial crises.

Quah, Chee Heong

Um, the Latin American crisis and S&L crisis were painful, but they precisely did not blow up the US. Switzerland and Iceland have entirely separate currencies from Ireland's participation in the Euro. That is what makes these arguments troubling, they tend to be the kind of non sequiturs that Geithner pursues.

The problem is two-fold: bad laws and bad enforcement. The government destroyed the firewalls between insurance, lending, and investing industries - all very different financial games. Then they started giving out money for free to the conglomerated financial megabanks. And they stopped checking on what those monsters were doing. Except they urged quasi-governmental agencies to compete in the housing bubble to do deals no matter what that meant for standards. And those terrible, ugly, amoral megabanks to the bait! How dare they!

Maybe, we should separate insurance and derivatives markets (risk management), from lending (risk for reward), from speculation (that is, venture capital and other forms of private banking). The economy needs all three, and all three sectors will have to abide by real regulation and enforcement. However, folks need to see each sector for its separate goals, risks, and rewards under a truly transparent regime.

The Fed could start by raising rates. Basel needs to clearly aim for 10% capital rates. The ECB clearly needs to hand out steep haircuts come 2013, as do Fannie, Freddie and FHA. They need to implement gold-standard loans for 20% down and LTV ceilings that are sustainable, as is being considered. Oh, and real tax and social security reforms need to be implemented to make everyone's social burden and cost transparent.

Pie in the sky? Maybe, but the future of the European and American social drag nets is unsustainable, both for private citizens and businesses. Germany is imposing real discipline on Europe, and Boehner and Obama have mentioned it in the US. Sure, the devil is in the details, but at least sustainability of all sorts finally is part of the discussion. When it makes it to the agenda, hope will at least darkent the door of the Western world. As long as citizens of a so-called democracy blame the dictators or the bankers, there is little hope of change.

"As countries grow and accumulate savings, they become increasingly prone to financial collapse." This is Keynes-speak. It should be: "As countries grow and attract unneeded investment, they become increasingly prone to greed and financial collapse." It also is inconsistent with the rest of the article. Geithner appears to think that continuing to invest the money the Fed is giving Wall St overseas will somehow boost American economic growth. It does have considerable historical precedent, but I am not sure it helped the British or Dutch anymore than it helped us in the past 50 yrs, and it wasn't printed money then.