Friday, February 3, 2012

Is Ed Milibrand's posturing setting the stage for requiring banks to adopt ultra transparency?

Philip Aldrick wrote an interesting column in the Telegraph in which he discussed how opposition to crony capitalism is picking up strength.  Specifically, he discussed what he felt were better ways to address issues like banker bonuses than the successful brute force methods being adopted by Mr. Milibrand.

What is important to note about Mr. Milibrand's efforts is they are setting the stage for real reform of the banks.

Mr. Aldrick argues for 'putting capitalism back in the heart of capitalism', but then suggests a number of solutions that are easily gamed and don't put capitalism back in the heart of capitalism.

Regular readers know that putting capitalism back in the heart of capitalism requires replacing opacity with transparency.

For the invisibile hand of the market to work properly buyers must have access to all the useful, relevant information in an appropriate, timely manner on what they are buying.  For banks, this information comes in the form of ultra transparency under which they disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Opacity allows bankers to make big bonuses by taking bets where the market cannot adjust the cost of the bank's funds to reflect the true riskiness of the bets.

Ultra transparency links the cost of the bank's funds to the riskiness of the bank.
Fresh from his victories on Stephen Hester’s bonus (Pyrrhic) and Fred Goodwin’s knighthood, Ed Miliband is back banging the “responsible capitalism” drum.... 
Capitalism has been rigged for far too long. Bankers were somehow excluded from the rules that the rest of us followed. Reform is needed that will put “capitalism back into the heart of capitalism”, as the Bank of England’s deputy Governor Paul Tucker succinctly put it. 
His boss, Sir Mervyn King, the Bank’s Governor, picked up the same theme last month. “Those who have suffered most have been those who accepted the disciplines of a market economy only to find that others were excused that discipline because they were ‘too important to fail’,” he said in words that clearly struck a chord with Miliband. 
Reforming capitalism will be the lasting legacy of the crisis.... 
What is needed is a change in the rules....
Contrary to reactionary sentiment, regulatory reform does not mean the end of free market capitalism. There are already rules in place. Lots of them. As Adam Smith made clear, markets need to be backed up by the rule of law. And many of those rules already have huge influence over behaviour.... 
Changing the rules again will just rearrange the free market, not kill it. 
And when it comes to bankers’ pay, far more intelligent people than me – mostly at the Bank – have come up with a bunch of good ideas. 
To start with, the way performance is measured should be overhauled. One compelling idea is to base it on return on assets rather than return on equity, as currently. Imagine buying a £100,000 house with a £10,000 deposit. If the price of the house rises to £110,000, you have doubled your deposit – your equity. That’s a 100pc return, but the asset has risen just 10pc. 
The debt multiplied what skill there was in picking the property tenfold. 
Debt works in the same way for bankers, where a 100pc return guarantees a bonus 10 times larger than a 10pc return. But there is one big difference. If the house price falls, you lose. If a banker’s investment falls, all they may lose is their bonus that year. Return on assets is a far superior measure of skill, and so a better way to measure rewards....
Of course, this assumes that bankers are not smart enough to figure out how to receive the same bonus using Return on Assets.
And then there is Miliband’s beloved issue of accountability. Shareholders currently don’t rein in the amount paid out in bonuses because the awards are presented as a done deal. Bonuses are qualified as “expenses” not distributions, such as dividends. If they were reclassified, then shareholders might be able to vote on the share of distribution....
Actually, without transparency there is no true accountability.  Transparency is needed so that the market properly prices the bank's securities to reflect the risks being taken by the bank.
Keen to ditch the anti-business mantle, Miliband does say: “Nobody begrudges exceptional rewards for exceptional performance. That is how capitalism should work.” He is right. Really good bankers, under the proposals above, could still be paid obscene amounts. But they would have to be really, really good, and most would get peanuts. 
Bankers should be well compensated if they can generate superior risk adjusted returns in a transparent environment.
If he is serious about fixing capitalism’s social ills he should propose some detailed changes to the rules that govern it, and then move out of the way. Given the right incentives, the free market would put responsibility back into capitalism all on its own.
Thank you Mr. Aldrick for inviting Ed Milibrand to propose that banks be required to provide ultra transparency.

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