Andy Haldane’s proposals for breaking the bankers’ doom loop

By Ian Fraser

Published: QFINANCE

Date October 25th, 2011

For a central bank director, Andy Haldane is remarkably alert to the widening cracks in the global financial system. Delivering the Wincott Annual Memorial Lecture in London on October 24, Haldane tried to shake policymakers and regulators out of their complacency by calling for a “fundamental shift” in their attitude to bank regulation.

In what may have been a veiled reference to Sir John Vickers (whose Independent Commission on Banking was, tellingly, not mentioned once in the speech), Haldane said it’s time policymakers and regulators stopped obsessing about the minutiae of banks’ balance sheets and started focusing on how to ensure banks serve, rather than destroy, the real economy.

In his speech Haldane reminded us that the banking status quo — in which bank managements continue to “rent gouge” by awarding themselves eye-watering pay, options and bonuses packages, despite their continued dependence on implicit state guarantees, their continued abuse of leverage, their continued obsession with short-term risk-taking and their cavalier disregard for other people’s money — is simply unsustainable.

He said simply imposing additional capital requirements does little to address these problems and summarized the current situation as follows:

“Ownership and control rights for banks are vested in agents comprising less than 5% of the balance sheet. To boost equity returns, there are strong incentives for owners to increase volatility. Those risk-taking flames have been fanned by tax and state aid.”

Breaking the circle

Haldane’s proposals for breaking the doom loop included eliminating some of the the tax benefits on debt, ensuring that banks use different metrics for calculating bankers’ pay, and broadening bank governance so that other stakeholders, including depositors and bondholders, have voting rights.

He said the traditional method of tying bankers’ bonuses to return on equity has been a recipe for disaster, as it encourages bankers to take ever riskier bets with billions of pounds of borrowed money – exactly the effect Sir Fred Goodwin’s dangerous obsession with the holy grail of RoE had at the Royal Bank of Scotland, with catastrophic consequences for the UK economy.

Haldane said the main reason average pay of the chief executives of large US banks had risen from $2.8m in 1989 to $26m in 2007 was that RoE was used as the main performance metric. He said if their pay had instead been linked to return on assets (RoA), which takes risk into account, their pay would have only grown from $2.8m to $3.4m – a real-terms fall of 68 times. Haldane said it would be a relatively small step for banks to base remunerations on RoA as opposed to RoE, but that the payoff for most non-bankers would be large.

Echoing the views of the QFINANCE contributor Andrew Smithers, Haldane warned against the use of share options to reward bank executives. He said this creates:

“an asymmetric payoff schedule [that] generates interesting incentives. The value of the equity option is enhanced by rises in the volatility of the bank’s assets. Why? Because volatility increases the upside return without affecting the downside risk. If banks seek to maximize shareholder value, they will seek bigger and riskier bets. Joint stock banking with limited liability puts ownership in the hands of a volatility junkie.”

Living in a dictatorship?

Haldane repeated an earlier call for the wider use of contingent convertibles (CoCos) – debt that converts to equity when a bank’s capital ratios fall below pre-set targets. He said “equity dictatorship”, where ownership and control remain in the hands of a small and diminishing band of liability holders, must be toppled. He said this would spread governance and control across the whole balance sheet, curbing the “rent-seeking incentives” in the equity dictatorship model.

“[The] risk/return imbalance has grown over the past century. Shareholder incentives lie at its heart. It is the ultimate irony that an asset calling itself equity could have contributed to such inequity. Righting that wrong needs investors, bankers and regulators to act on wonky risk-taking incentives at source.”

Haldane said the massive implicit state guarantees that are still provided to banks by increasingly pissed-off taxpayers, worth $340bn a year in the UK alone, imperil both the banking sector and the wider economy. He highlighted the thorny problem of the too-big-to-fail bank:

“Too-big-to-fail heightens the time-consistency dilemma for managers and policymakers. Big, connected firms increase the chances of a bad situation turning not just worse but catastrophic. Knowing the authorities will shoulder that tail risk, debt-holders will not price it for themselves. That is doubly unfortunate, as it means debtor discipline will be weakest among institutions for which society would wish it to be strongest. Worse than that, bigger banks will then benefit from an implicit state subsidy, for cheaper debt means fatter profits. That might itself encourage further risk-taking.”

Haldane asked who has really prospered as a result of massive distortions in the banking sector. His answer: hardly anyone.

“Long-term shareholders in banks have not obviously reaped the benefits of these distortions. The purchaser of a portfolio of global banking stocks in the early 1990s is today sitting on a real loss. So who exactly is it extracting value from these incentive distortions? The answer is twofold: shorter-term investors and bank management.”

This article was first published on QFINANCE on October 25th, 2011

Further reading on the urgent need for fundamental reform of the banking sector:

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1 Comment for “Andy Haldane’s proposals for breaking the bankers’ doom loop”

  1. […] Haldane – here (hattip-IF) – obliges the question of how come banker people can stick around on such big […]

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