Opacity combined with banks' focus on equity returns harms the financial system

According to a Telegraph article, another member of the Bank of England's Financial Policy Committee has asserted that banks' focus on return on equity has harmed the financial system and that a better result would be achieved by refocusing pay on return on assets or return on risk weighted assets.

Actually, it was the combination of opacity and the banks' focus on return on equity that harmed the financial system.

Bankers needed opacity to hide the risks that they were taking to maximize their personal earnings.

Without opacity, it would have been possible for market participants to exert market discipline and prevent the bankers from taking as much risk as they did.

Regular readers know that your humble blogger thinks that changing bank compensation is an indirect, opaque method for addressing banks' risky behavior.

The direct method is to require banks to disclose their current assets, liabilities and off-balance sheet exposures at the end of each day.

With this disclosure, market participants can actually directly assess the riskiness of a bank.  Based on this assessment, market participants can adjust both the amount and price of their exposure to the bank.

With disclosure, what will ultimately be rewarded is building a banking franchise with high net income and low risk.

Robert Jenkins, a former City banker and a member of the FPC, said the use of return on equity (ROE) targets had encouraged banks to chase ever higher returns without taking account of the risks involved. 

Mr Jenkins argued the use of ROE as a measure of a bank's performance had led to a situation in which "many bank share investments have proved the equivalent of capital contributions to not-for-profit companies employing exceedingly well-paid staff". 

"It is time for shareholders to insist on a proper alignment of bank pay practices with the interests of their owners. Wipe the slate clean of accident-prone objectives and substitute new pay proposals which give bankers the incentives to do what many say they were doing but weren't – building shareholder value," said Mr Jenkins.... 

ROE is measured by dividing post-tax profits by shareholder equity to calculate a percentage return. 

In the boom years before the onset of the credit crunch in 2007 banks routinely targeted ROEs in the high teens and 20s. However, since then they have had to rein in expectations. 

Barclays and HSBC have both set themselves a target of achieving returns of about 13pc but many analysts and investors remain sceptical that even these lower figures will be achievable. 

Mr Jenkins said that banks must drop ROE targets altogether and look to measure their performance based on a calculation that would take include the risk taken by the business to achieve the return. 

Two measures he thinks might fulfil this role would be a return on assets (ROA) target or a return on risk-weighted assets performance measure. These figures would take into account the total return a bank made on all its assets and would, according to Mr Jenkins, give a better indication of how a bank is performing. 

"Looking at a number of those banks destined for the dustbin shows that in the years preceding the bust, ROA was falling even as ROE was rising," he said.