Economics

Bankers’ bonuses and unlimited liability

On the 29th of February, Conservative MP Steve Baker tabled a 10 minute rule bill on bankers’ bonuses. In it he proposes that directors of financial institutions post personal bonds that can be called in should an institution they hold responsibility for fail. Essentially, this increases the liability of directors of financial institutions to a far greater, and personally significant, level.

This is an interesting proposal and one that is supported by a number of luminaries – the Bank of England’s financial stability guru Andy Haldane being one, and the substance of the bill has been crafted by professor Kevin Dowd and Gordon Kerr, himself a banker and founder of Cobden Partners. This is certainly timely and the whole debate about bonuses is far from being settled. But in looking for a long term solution to this question of remuneration, it is worth casting an eye to the pre Big Bang City, when soon-to-be-created investment banks were still merchant banks, jobbers and brokers. This was a time when membership of the London Stock Exchange required that member firms could either be a broker, acting as an agent between end users and the market itself for a fixed rate commission, or a jobber acting solely as a market maker and prohibited from any contact whatsoever with the end use investor. As a fresh faced junior on the floor of the Stock Exchange in 1982 – a “blue button” – I was paid a base salary of £3,500 per annum, with an indicated bonus of 65% paid at a rate of 15% each quarter with the final 20% at the year end, depending on results and personal performance. The reason for this arrangement was two-fold. Firstly, there was (and still is) a requirement that all regulated firms hold a reserve of regulatory capital that is equivalent to 90 days operating costs. Reduce your fixed costs by having a low base salary (topped up by non-guaranteed bonuses) and you reduce your regulatory capital requirement. But the second reason relates to the structure of the firms themselves. Unlike modern businesses, the pre Big Bang firms were unlimited liability partnerships. The partners of the firms wanted to mitigate their liabilities until they knew how profitable they had been at the year end and so we staffers put up with a slightly erratic method of remuneration.

But it was this element of unlimited liability that was a key to the stability of the City. Every member firm had a group of individuals running it who had a huge vested interest in the financial stability of the firm. Every partner watched his or her part of the business like a hawk and was party to every decision on expenditure and risk taking. It was an incredibly effective system. Every partner knew that if he or she messed up, it was not just their bonus or their job they were losing: they would lose their home, their son would be chucked out of their private school, their daughter would have her pony repossessed by an unsympathetic bailiff, and the Jaguar would go back to the showroom. Everything would be gone including their dignity. The fact is, there is no better way to regulate risk than have the deal maker waking up at three in the morning in a cold sweat about an ill conceived decision.

Wind forward twenty or so years and the deal maker’s downside is now no more than his or her job. If it is a terrible error they have made, at best the shareholders of the bank pick up the bill; at worse, the taxpayer.

Steve Baker’s bill seeks to move some way towards restoring this old regime. By posting a bond as part of the regulatory capital of a bank, as Steve’s bill proposes, the liability of an individual director is part guaranteed. But the director has, ultimately, unlimited liability on the debts of the firm he governs. The recovery capital – that which the director will cough up should the bond be called in – is a minute fraction of the potential liability of any of the significant institutions concerned. With balance sheets reaching a trillion pounds or more, a director’s personal wealth will never make a significant difference to losses. But committing a risk taker at an institution to effectively put up his life’s accumulated worth is a serious and effective way of ensuring that this individual thinks far more carefully when looking to speculate with someone else’s balance sheet.

However, I fear that Steve’s bill, whilst a smart way of ensuring risk is mitigated from those at the top of an institution – the directors – may not go far enough. After all, very few directors of these institutions will be aware of the day-to-day activities of any trading desk. Far more effective would be a solution whereby those heading up business divisions of regulated institutions would carry a liability restricted to just those areas under their control. Spreading the risk amongst a wider range of those on the payroll would generate more capital and so be a more realistic resource in the event of a failure. It would also be a far more effective way of ensuring a wider spread of risk takers buy into the risks associated with their activities. In return, those who are prepared to participate in the risk element of the business would be able to participate in generous bonus schemes and the moral hazard that is a significant feature of the current bonus schemes would be eliminated.

Of course, details would need to be looked at in terms of what constitutes risk business and non-risk, agency business. But what is important about Steve Baker’s bill is that it opens a new area of debate restoring the risk / reward balance in favour of the taxpayer. With a system so jammed packed with moral hazard, Steve’s thinking is a helpful contribution to a complex and important issue.

Economics

The 2012 Baker Bill: a programme to end financial crises

Earlier today Conservative Steve Baker MP put forward a Private Member’s Bill, the Financial Institutions (Reform) Bill, which outlines a programme of radical reforms to the banking system and calls for an end to state meddling in banking. Steve is co-founder of the Cobden Centre, and has been MP for Wycombe since May 2010.

The underlying principle of his Bill is to minimize moral hazards within banking, by making those who make or preside over risk-taking as liable as possible for the consequences of that risk-taking. Since financial institutions often circumvent rules, the Bill also includes mutually reinforcing measures that minimize scope for evasion.

Within this framework, bankers would be free to do as they wished, but they would bear the consequences of their own actions.

Thus, Steve’s Bill addresses the rampant moral hazard problems within the modern banking system, and this is the central issue in putting the banking system back on its feet and restoring its integrity. Indeed, his proposals provide nothing less than a free-market solution to the current banking crisis

I would therefore ask all supporters of free markets to promote this Bill and to push for similar measures in other countries.

One key provision of the Bill is to make bank directors strictly liable for bank losses and require them to post personal bonds as additional bank capital. These measures reaffirm unlimited personal liability for bank directors, and will rule out all-too-familiar “It wasn’t my fault” excuses on their part.

The Bill also calls for bonus payments to be deferred for five years, and for the bonus pool to be first in line to cover any reported bank losses. Any reported losses would be covered first out of the bonus pool and then out of directors’ personal bonds before hitting shareholders.

These measures would provide strong incentives for key bank decision-makers to ensure responsible risk-taking, as their own wealth would now be very much at risk.

Amongst other measures, the Bill:

  • Proposes a tough bank solvency standard, and would require any insolvent bank to be automatically put into receivership;
  • Calls for the Government to propose a fast-track receivership regime for insolvent banks and to produce a plan and associated timetable to end all state involvement in the banking system;
  • Calls for accounts to be prepared using the old UK GAAP governed by Companies Act legislation, as proposed in Steve’s previous (2011) Private Member’s Bill, the Financial Services (Regulation of Derivatives) Bill. This would put an end to the various accounting shenanigans associated with IFRS accounting standards; and
  • Calls for the establishment of a Financial Crimes Investigation Unit to investigate possible crimes committed by senior bankers: this Unit would investigate all banks that have failed or received public assistance since 2007 and would replace the Financial Services Authority, which has proven to be utterly useless.

Further details of the Bill can be found on Steve’s website:

Economics

Speech on the Financial Services Bill

Under the heading, Osborne looks to limit damage of ‘credit busts’, the FT gives a neat summary of the Chancellor’s plans. In particular:

He said the FPC would also look out for dangerous linkages in the financial system and identify exotic new instruments that might undermine stability. It would be charged with containing credit booms as well as limiting the damage of “credit busts”.

Which this morning caused me to regret that I was not given time in the Commons at the second reading of the Financial Services Bill to quote from the 1932 preface Hayek’s Monetary Theory and the Trade Cycle:

There can, of course, be little doubt that, at the present time, a deflationary process is going on and that an indefinite continuation of that deflation would do inestimable harm. But this does not, by any means, necessarily mean that the deflation is the original cause of our difficulties or that we could overcome these difficulties by compensating for the deflationary tendencies, at present operative in our economic system, by forcing more money into circulation. There is no reason to assume that the crisis was started by a deliberate deflationary action on the part of the monetary authorities, or that the deflation itself is anything but a secondary phenomenon, a process induced by the maladjustments of industry left over from the boom. If, however, the deflation is not a cause but an effect of the unprofitableness of industry, then it is surely vain to hope that by reversing the deflationary process, we can regain lasting prosperity. Far from following a deflationary policy, central banks, particularly in the efforts than have ever been undertaken before to combat the depression by a policy of credit expansion—with the result that the depression has lasted longer and has become more severe than any preceding one.

After a number of interventions about the futile search for stability and the breach of the rule of law inherent in the proposals, I said,

I very much welcome the Bill, which I hope and believe will prove to be the zenith of contemporary thought on bank reform. With due deference to my right hon. Friend the Member for Hitchin and Harpenden (Mr Lilley), I wish to talk about three potential elephants in the room. First, I wish to make some remarks about accounting, then I wish to discuss the conduct of individuals and liability, and finally I wish to talk about financial stability.

I know that the Minister has heard my views on the international financial reporting standard, but I draw his attention to a letter in yesterday’s Financial Times by Lord Lawson, under the headline “Forget Fred and focus on the real banking scandal”. He stated:

“The auditing of banks’ accounts, however, is fundamentally flawed in itself. The IFRS accounting system itself has proved to be damagingly pro-cyclical, and the ability to pay genuine (and genuinely large) bonuses out of purely paper profits, which are never subsequently realised, is at the heart of both the bonuses that cause such public and political outrage, and the reason why bank management consistently does so well when bank shareholders do so badly.”

Andy Haldane, the executive director for financial stability at the Bank of England, gave a speech in December. I shall not read out all the remarks that I meant to cover, but he concluded by saying that

“if we are to restore investor faith in banking sector balance sheets, nothing less than a radical rethink may be required.”

He was referring, entirely, to accounting standards. I therefore refer the Government to my private Member’s Bill introduced on 13 May 2011, which seeks to introduce parallel prudent accounting for banks. It is a couple of pages long and I hope that it can be added to this Bill.

I also refer the Government to “The Law of Opposites”, a paper produced by the Adam Smith Institute and written by my colleague Gordon Kerr, who has spent 25 years “gaming accounting rules”, as he would perhaps say, in order to make a profit. The banking system is in a far worse state than is generally believed. I do not see how either the Financial Policy Committee or the prudential regulation authority can operate without a true and fair view of the state of financial institutions, and I do not believe for a moment that the international financial reporting standards give that to us.

On the conduct of individuals, we fail too often to think about the pattern of regulation in which we have engaged. It seems that the first thing that legislation does is to damage the incentives and disciplines of the market. Having thereby created moral hazard, regulators come along to try to mitigate the consequences of that moral hazard. A banking licence today is a licence to lend money into existence, at interest, with the risk socialised. When we look at central banking, deposit insurance and limited liability, we find that moral hazard is absolutely rife in the banking industry, even before we consider investment banking. I suggest to the Government that it is time to increase the liability of banks’ directors. There should be strict liability for them, and bonuses should be held in a pool and treated as capital for at least five years. I will introduce a private Member’s Bill to that effect on 29 February.

We have talked about financial stability and the difficulty of defining it. There has been a sense that there is some kind of equilibrium economy—an evenly rotating one—in which there could be a sustainable and stable quantity of credit. Indeed, on pages 14 to 16 of the Joint Committee’s report there is an interesting discussion about the need to regulate credit.

To leave time for my hon. Friend the Member for North East Somerset (Jacob Rees-Mogg), I will just say that if we were talking about any other commodity and were discussing adding to a failed regime of price control a regime of quantity control, we would certainly reject the idea out of hand. In Lord George’s testimony to the Treasury Committee before the crisis, he made it absolutely clear that the Bank of England had created a credit bubble to avoid falling into recession, yet we are going to give the Bank even more powers, more tools, [resulting in] more risk of ruin and more big-player effects and distortions of economic expectations.

I congratulate the Government on introducing the Bill, and I sincerely hope that it represents the absolute zenith of contemporary thinking on interventionist bank reform.

In the following video, my remarks begin at 21:31:

I should think society will learn, in the next few years, some important lessons about the use of arbitrary power by monetary and financial authorities. Hold tight.

This article was previously published at stevebaker.info

Economics

Greg Mankiw Ponders Greenspan’s Paper the Crisis and Considers 100% Reserves

We are grateful to Robert Arbon for pointing out this article on Greg Mankiw’s Blog:

I just returned from the spring meeting of the Brookings Papers on Economic Activity, where I was a discussant for Alan Greenspan’s new paper on “The Crisis,” which has gotten a bit of media attention. I thought blog readers might enjoy reading my comments on the paper. Here they are:

This is a great paper. It presents one of the best comprehensive narratives about what went wrong over the past several years that I have read. If you want to assign your students only one paper to read about the recent financial crisis, this would be a good choice.

There are, however, particular pieces of the analysis about which I am skeptical. But before I get to that, let me begin by emphasizing several important points of agreement.

To begin with, Alan refers to recent events in the housing market as a “classic euphoric bubble.” He is certainly right that asset markets can depart from apparent fundamentals in ways that are often hard to understand. This has happened before, and it will happen again. When the bubble bursts, the aftershocks are never pleasant.

Read more.