Friday, February 8, 2013

BoE's Robert Jenkins: "banks should defer bonuses for 10 years"

Bloomberg reported that the Bank of England's Financial Policy Committee member Robert Jenkins suggested that banks should defer bonuses for 10 years so that executives were not compensated prematurely for the risks taken to earn the bonuses.

Your humble blogger does not quibble with the need for a careful rethink of how bankers are compensated.  However, I don't think that regulators should be leading the charge in this area.

Regulators should be focused on making sure that transparency is being brought to all the opaque areas of the financial system so that market participants can properly assess risk.

For example, banks should be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this information, market participants could assess the risk of each bank and adjust their required return on their investment in each bank to its level of risk.

Linking a bank's cost of funds to its risk would result in a substantial change in each bank's risk profile. Specifically, it would provide an incentive for each bank to lower its risk profile.

Key point:  the regulators should focus on subjecting banks to market discipline so the banks reduce their risk profiles.

Regulators should leave it up to the shareholders how they want to split the bank's earnings with its employees. 

The shareholders know that with the banks providing ultra transparency they are responsible for losses on their investment should a bank need to be resolved.  This gives the shareholders plenty of incentive to restructure the way a bank's earnings are shared between the bank's employees and shareholders so that the shareholders get compensated for the risk they are taking on as investors.

Bottom line:  The FDR Framework gives investors the incentive to exert market discipline on banks to reduce their risk profiles and to rethink banker compensation because the investors are responsible for all losses on their investments.
Bankers’ bonuses should be deferred for as long as 10 years to hold executives accountable for risks, said Robert Jenkins, a member of a Bank of England committee charged with ensuring financial stability. 
“Five years might or might not be appropriate for some categories of risk, but if we are going to rely on remuneration as a key driver of financial stability then it should probably be between five or ten years,” Jenkins said in an interview yesterday in Washington. 
“Ten years would capture the majority of risk cycles and therefore the gains and losses that came from any risk that was taken today.”
We should definitely not rely on renumeration as a key driver of financial stability.

The key driver of financial stability in the global financial system is and has been for the last 7+ decades transparency.

If you look at all the parts of the financial system that stopped functioning at the beginning of the financial crisis, each of them is opaque (think structured finance securities and banks).
Jenkins’ comments echo those of Andrew Haldane, another member of the BOE’s Financial Policy Committee, and signal U.K. regulators may continue to push banks to reduce risks. 
The central bank, which is adding regulatory powers to its monetary- policy remit, said in November banks may need to raise more capital to cover loan losses and that they may have overstated their capital strength.
If the BoE really wants to push banks to reduce risks, it must champion requiring banks to provide ultra transparency.

Banks can currently provide ultra transparency on a borrower privacy protected basis, but bank management prefers not to.  Why?
The problem “is that very large sums of money can be given to risk takers as a reward for the apparent profitability on the risks that they take before the risks have matured and before anyone knows for sure that it was profitable,” said Jenkins...
The big problem is not that bankers are rewarded before it is known if the risks taken are profitable.

The big problem is that bankers can take risks without being subject to market discipline and having their cost of funds change to reflect the degree of risk they are taking.
Jenkins, who previously worked at Credit Suisse Group AG and F&C Asset Management Plc, also called for higher capital requirements and said “too-big-to-fail, too-big-to-bail and too-big-to-jail” institutions remain a challenge for regulation.
The too-big-to-fail-bail-or-jail banks would not be a challenge for regulation if global financial regulators focused on requiring the banks to provide ultra transparency.

Subjecting each of these banks to market discipline would bring about substantial changes.

For example, the market would punish the complexity of these banks.  All of their subsidiaries involved in regulatory and tax arbitrage would be seen as adding risk.  It doesn't take much of a boost in a bank's cost of funds before they would jettison these subsidiaries.

For example, market discipline would end the banks taking proprietary bets.  Every trader knows that if their bets are disclosed other market participants will engage in trades that minimize the profit potential of their bets while maximizing the loss potential (see JP Morgan's Whale Trade for example).

Bottom line:  banks have been shielded from market discipline by the regulators for the last 3+ decades and the result is global financial institutions that are effectively too big for the regulators to deal with.

Fortunately, there is an entity that is still bigger than these institutions that carries the necessary clout to truly reform these institutions: the market.  What the market needs to exert discipline and shrink these institutions to a manageable size is transparency. 

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