Sunday, December 4, 2011

Bank of England: crackdown on bankers' bonuses

The Telegraph reports that the Bank of England is preparing a regulatory crackdown on the out of control bonus culture that exists in finance.

Regular readers know that rather than try to stop excessive bonuses through a regulatory crackdown, I prefer to reduce them by requiring ultra transparency.

Ultra transparency is a trader's worst nightmare.  Ultra transparency requires disclosing on an on-going basis current asset, liability and off-balance sheet exposure details.

Traders hate it because it lets market participants trade against them.  This includes piling into and out of trades before the trader has a chance to take a meaningful position or can exit their position.

In case there is any doubt about this, Warren Buffett negotiated with the SEC to keep his trades confidential.

Ultra transparency is also a bank CEO's worst nightmare.  Ultra transparency shines a very bright light on a bank's efforts to increase its earnings (the return in Return on Equity or Return on Assets) by increasing its risk.

With ultra transparency, market participants can assess the risk of the bank and adjust both the amount and price of their exposure to reflect this risk assessment.  As risk goes up, so does the cost of funds to the bank.

Finally, with ultra transparency, there is no need for specific regulations on payments to bankers.  If they can deliver high earnings with verifiably low risk, they should be rewarded with high pay.

The Bank has warned lenders it is considering changes to the way bonuses are measured to make it far harder for big-hitting investment bankers to justify their multi-million pound awards. 
The threat follows the central bank's decision last week to force British lenders to "limit" bonuses this year in order to shore up their balance sheets against the looming eurozone crisis....
The threat of a bonus crackdown was made in the Bank's Financial Stability Report. It said the Financial Policy Committee (FPC), which has the power to set new rules, had "noted that performance metrics, such as return on equity targets, that take little account of the risks taken to achieve them could be distorting incentives". 
It added: "Given the importance the committee attaches to this issue, it agreed to consider it in greater depth at a future meeting. It would consider, among other things, the extent to which such performance metrics influence …remuneration." 
The disclosure appears to be an early warning that reform is coming. 
At least two leading members of the FPC have been campaigning for change for some time, endorsed by the Bank. 
Robert Jenkins, an external member, said earlier this month: "Return on equity is the wrong target. Over the last 10 to 15 years it has helped to make many bankers rich and loyal shareholders poor." 
Although technical, the reform would have far-reaching implications. Return on equity, or RoE, rewards bankers for taking risk that in the recent crisis was ultimately borne by taxpayers. 
Instead, both Andy Haldane, the Bank's executive director of financial stability and a member of the FPC, and Mr Jenkins believe that bonuses should be measured against return on assets, or RoA, which adjusts for risk. 
"While the risks have typically been borne by wider society, the returns have been harvested by bank shareholders and managers," Mr Haldane has said. 
According to his analysis, the effect on bonuses from switching targets would potentially be huge. Between 1989 and 2007, in which time there was "increasing focus on RoE as a performance target", the average pay of the top seven US investment bank bosses rose from $2.8m to $26m. If their performance had been linked to RoA, it would have increased to just $3.4m. 
"Rather than rising [from 100 times] to 500 times median US household income, it would have fallen to around 68 times," Mr Haldane said.... 
According to Mr Haldane: "In effect, RoE is skill multiplied by luck."

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