Monday, October 24, 2011

Bank of England's Andy Haldane wants to overhaul bankers' pay

According to an article in the Guardian, the Bank of England's Andy Haldane would like to overhaul bankers' pay.  In particular, he would like it switched from emphasizing return on equity to emphasizing return on assets to more accurately align pay with the risks being taken by the bank.

In point of fact, should the Bank of England adopt Mr. Haldane's proposal, it would incentivize bankers to take greater risk to maintain their pay.

As George Akerlof described in his seminal article on accounting control fraud, bankers can increase return on assets in the short-run by lending to riskier borrowers.  These borrowers pay a higher rate of interest which initially boosts ROA.  Bankers would be paid on this initial boost and not the subsequent decline in earnings when the bad debt comes due.

Regular readers know that there are two simple steps to fix the problems Mr. Haldane sees with bankers' pay without requiring a change in bank compensation plans.

First, regulators must require that banks disclose their asset and liability details.

Market participants can use this data to assess the risk of the bank and to adjust both the amount of and price of their exposure to the banks.   This market discipline will act as a brake on bank risk taking.  As a result, large bonuses will have to be earned the old fashion way - through delivering high earnings at low risk.

Second, regulators need to require banks to recognize the losses on their balance sheets.  Had this been done, banks' return on equity since the beginning of the financial crisis would not have merited any bonuses for their executives.
Bankers' pay should be radically overhauled, according to one of the Bank of England's most senior policymakers, who has called for a closer link between bonuses and the risks taken by banks.
Andy Haldane, the Bank of England's executive director for financial stability, argued that if the performance of bankers had been measured against loans rather than share prices, there would have been a dramatic reduction in their pay levels in the past two decades.
Speaking in a personal capacity, he said "deep-rooted incentive problems in banking need to be tackled". 
Analysing the pay of the chief executives of the biggest seven banks in the US, Haldane reckoned that the average pay had risen tenfold from $2.8m (£1.75m) in 1989 to $26m in 2007 because it was linked to return on equity (ROE). But if it been had based on the risks their banks took in granting loans, return on assets (ROA), their pay would have risen much more slowly – from an average $2.8m to $3.4m. 
"If you believed ROE were a reliable performance metric, US bank CEOs would have had a watertight defence back in 2007. Indeed, it was the L'Oréal defence: because we're worth it. But experience since suggests this performance was cosmetic," he said. 
Haldane, who is concerned about risks in the financial system and their wider impact on society, noted the "eye-popping" implicit guarantee to the UK banking system from taxpayers of $340bn per year – or $1.3tn globally – and said that while bankers have benefited from the risks they have taken, wider society is carrying the cost. 
"In England and Wales alone, over half a million individuals and nearly 100,000 businesses have found themselves in insolvency since 2007. Internationally, a growing number of sovereign states face a similar fate. This tells us that the risks from banking have been widely spread socially. But the returns to bankers have been narrowly kept privately," said Haldane. 
"That 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," he said....
Haldane set out a detailed argument to measure performance against assets (loans in the case of banks) rather than equity, arguing that ROE "flattered returns, and hence compensation" during the good times because it puts risks ahead of long-term returns. 
"It would be a relatively small step for banks to switch from ROE to ROA targets in their capital planning and compensation. Yet the effects on risk-taking and remuneration could be large," he said. 
It would have contained the rise in pay for bank chief executives in the US between 1989 and 2007. "Rather than rising to 500 times median US household income, it would have fallen to around 68 times," he said.

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