Who guards the guardians and the growing myth of bankers' pay

Harry Wilson in a Telegraph article reports that bankers have put the issue of who guards the guardians onto the table and have taken exception to the growing myth that the financial crisis was the result of bankers' pay.

Let me address the issue of bankers' pay first as I have already written several posts on it recently (see here and here).

According to the bankers, pay is not the source of all evils.

Defending industry pay practices while giving evidence in front of a joint committee of MPs and members of the House of Lords, Mr Hester admitted that large bonuses had been a problem in the past, but that banks had "moved the dial" on financial services industry pay. 

Mr Hester was backed up by Bob Diamond, chief executive of Barclays, and Stuart Gulliver, chief executive of HSBC, who agreed that bankers' pay had been unfairly blamed for causing the financial crisis. 

This blog has repeatedly shown that it was not bankers' pay that caused the financial crisis, but rather opacity.  It was opacity that provided cover to the bankers so that they could take risks that maximized their pay in the short run.

However, Mr Gulliver conceded that if a bank got into trouble the authorities should have the power to curb the payment of bonuses to staff to minimise the amount of public support that an institution might need.

I would go further than curb the payment of bonuses, I would have well known guidelines for clawing back pay from earlier periods.

"I would see that as one of the tools used at recovery point but not at other times, because otherwise you then have regulators as shadow directors," he said.

Mr. Gulliver explicitly raises the question of what is the proper role of regulators.  Is pay an issue to be determined by a bank's board of directors or by regulators?

Your humble blogger thinks that pay should always be determined by the bank's board of directors.

The role of the regulators under the FDR Framework is to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner.  With this data, market participants can assess the risk that the bank takes on and adjust both the amount and price of their exposure accordingly.

The result is that bankers who are compensated for generating either Return on Equity or Return on Assets will not necessarily receive more compensation for taking greater risk.  Market participants will increase the cost of the bank's funds as the risk of the bank increases, so it is far from clear that there is any gain to be had from more risk.

The bank chief executives then raise the interesting question of who guards the guardians?

Under the FDR Framework, it has always been explicit that it is market participants who oversee both the banks and the regulators.  With disclosure of each bank's current assets, liabilities and off-balance sheet exposures, market participants can help regulators identify both individual bank problems and systemic problems.  Naturally, market participants can see when regulators take action.

Compare that to what currently exists where regulators have both a monopoly on all the useful, relevant information and, when they are part of a central bank, have limited oversight.  Under these conditions, market participants have no idea if the regulators have identified individual bank or systemic problems and they have no idea if the regulators have taken action.

Clearly in the run up to the financial crisis in 2007, it appears that the regulators did not identify individual bank or systemic problems nor did the regulators take action.  MF Global appears to show that the regulators still are not identifying individual firm problems and taking corrective action.

This model of regulators having an information monopoly and market participants being dependent on them to properly identify and take action on problems clearly does not work and needs to be replaced.

Your humble blogger has long advocated ending the regulators' information monopoly and enlisting the market and its participants to help the regulators enforce discipline on banks.

The three bankers were united in their criticism of the governance arrangement of the Bank of England, which they argued needed more oversight from politicians and the business community.... 

Mr Gulliver ...  added he was "uncomfortable" with the concentration of power in the Bank. 

"If you compare this with a corporate structure you have the equivalent of a CEO, who for political reasons is hired for five years and can't be fired and who has no real board who can check him or her," said Mr Gulliver. 

Mr Diamond agreed and said the Bank should face more oversight from the Government. "Would the Committee feel the same if this was a listed bank?" he said.