Wednesday, November 9, 2011

How we got here and what is the way forward with bank reforms

Andrew Haldane, Executive Director at the Bank of England, is one of the leading and credible voices championing financial regulation reforms so as to prevent a recurrence of events that led to the sub-prime mortgage meltdown. His most recent speech, the Wincott Annual Memorial Lecture, is an excellent chronicle of banking industry and summarizes his reform proposals.

He describes the source of a governance fault-line in banking sector,

"Ownership and control rights are exercised by shareholders. But for banks, equity is a vanishingly small fraction of their balance sheet. Worse still, equity-holders often have risk-taking incentives out of line with the interests of other bank stakeholders, much less society. This fault-line lies at the heart of the imbalance between privatised returns and socialised risks. Only in banking do control rights and incentive wrongs combine so uncomfortably."

He traces the evolution of the banking sector since the nineteenth century - unlimited liability moved to extended liability and finally to limited liability. Given limited liability, bank managements realized the benefits of excessive risk taking - the downside losses were capped, while the upside gains were all theirs. This meant that volatility with high upside gains increased the returns on equity. Similarly, higher leverage too enabled equity holders to amplify their returns on equity.

With equity holders having increasingly limited skin in the game, the other possible restraint on excessive risk taking, arising from debt holders (who could either have demanded higher returns on their investments or even denied their funds), too started breaking down. The disciplining role that debt holders had exercised on banks started failing for various reasons, the most prominent being the realization that governments will step in and bail out failing banks.

A measure of the too-big-to-fail (TBTF) subsidy of UK and global banks, based on different models, rose dramatically in the build-up to the sub-prime crisis. For the global banks, the TBTF subsidy is worth at least hundreds of billions of dollars per year. This subsidy is also a measure of the risk mispricing by bank debtors, and by implication also the extent of dilution in debtor discipline.

Finally, there is the executive compensation system that rewards short-term equity market gains over more sustainable value addition. Return on equity (ROE), with quarterly periodicity, has become the guiding post on evaluating manager performance and shareholder returns. Haldane describes how the shorter-term investors in bank equities gained from volatility,

"Institutional investors in equities are typically structurally long. They gain and lose symmetrically as returns rise and fall. Many shorter-term investors face no such restrictions. If their timing is right, they can win on both the upswings (when long) and the downswings (when short). For them, the road to riches is a bumpy one – and the bigger the bumps the better. As in Merton’s model, all volatility is good volatility. Perhaps reflecting that, there is evidence of the balance of shareholding having become increasingly short-term over recent years... Average holding periods for US and UK banks fell from around 3 years in 1998 to around 3 months by 2008. Banking became, quite literally, quarterly capitalism. Today, the average bank is owned by an investor with a time-horizon considerably less than a year...

What we have, then, is a set of mutually-reinforcing risk incentives. Investors shorten their horizons. They set ROE targets for management to boost their short-term stake. These targets in turn encourage short-term risk-taking behaviour. That benefits the short-term investor at the expense of the long-term, generating incentives to shorten further horizons. And so the myopia loop continues."

Increased volatility, high leverage, and distorted basis for calculating management compensation and return on shareholder investments favors the short-term investor and the management over all others. All this coupled with the basic "governance fault-line" meant that incentives became badly mis-aligned all round.

He captures the results of all this in a few stunning figures. In the 1880s, total UK bank assets were equal to 5% of GDP. At the bubble peak they were 500%. The assets of the UK’s three biggest banks at the start of the 20th century were 7% of GDP. By the end of it they were 75%, and by 2007 it was 200%. Leverage climbed from 3-4 times in the 19th century to 30 times in the bubble. And return on equity went from modest single figures to 30% at the peak. As to executive compensation among the CEOs of the seven largest US banks, in 1989 it averaged $2.8 million, or almost 100 times the median household income. By 2007, it had risen ten-fold to $26 m, over 500 times the median US household income. Most astonishingly, temporary support for the global banking system during the crisis peaked at around a quarter of global GDP.

Haldane suggests four financial market regulation proposals

1. Higher equity capital. He writes about its benefits

"It would put more skin in the game for equity-holders, thereby reducing their incentives to extract option value. It would reduce leverage directly, thereby reducing banks’ capacity to risk-up. And it would increase banks’ capacity to absorb loss, thereby reducing the probability of official intervention."

He favors much higher capital reserve ratios than that being considered under the Basel III norms. More radically, he favors equalizing the scaales between equity and debt, thereby forcing debt holders to have much greater skin in the game and encourage them to play their traditional disciplining role.

2. Equity-like liabilities

He favors the use of financial instruments which explicitly combine the incentive features of debt and equity, the so-called contingent convertible securities or CoCos. They are debt in good times, but convert to equity in bad, and combines the benefits of unlimited liability without its practical drawbacks.

However, such instruments should be time-consistent (they should kick-in without discretion and expectations of its kicking in should not distort market incentives).
He suggests that the bank management should have no discretion on when and how conversion takes place. Further, conversion needs to take place well ahead of bankruptcy, thereby avoiding the deadweight costs of default which, for too-big-to-fail institutions, are likely to be too large to be tolerable by the authorities.

As a trigger for the conversion, Haldane prefers market-based measures of capital adequacy, like even equity prices. This would be better that regulatory ratios which can be tweaked to suit requirements. Such triggers would expedite pre-emptive recapitalisation of failing institutions and contain the spread of risks.

3. Control rights

Haldane prefers a ownership and control rights model that is a right mixture of the two extremes of a public limited company (rights vested in a small minority and voting rights assigned according to portfolio weights – an equity dictatorship) and the mutually-owned co-operative (rights spread over a wide set of liability-holders, with voting rights unrelated to portfolio weights – a liability democracy). Voting rights could be extended across a wider set of liability stakeholders, with rights allocated on the basis of their deposits, thereby ensuring that governance and control are distributed across the balance sheet - a wealth-weighted democracy.

4. Performance and compensation

he advocates moving over from a system of evaluating performance based on ROE to one based on return on assets (ROA). This covers the whole balance sheet and, because it is not flattered by leverage, does a better job of adjusting for risk. He writes that if the CEOs of the seven largest US banks had in 1989 agreed to index their salaries not to ROE, but to ROA, by 2007, their compensation would not have grown tenfold but would have risen from $2.8 million to $3.4 million. Rather than rising to 500 times median US household income, it would have fallen to around 68 times.

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