Wednesday, December 8, 2010

Why bankers' incentive issue is still on the agenda?

From January 2011, Dutch banks must have a sound remuneration policy essentially according to the 2010 CEBS guideline , ".., because excessive and imprudent risk-taking may undermine the financial soundness of financial institutions and destabilise the banking system, .." (page 37). Furthermore, a sound "remuneration policy is consistent with and promotes sound and effective risk management and does not encourage risk-taking that exceeds the level of tolerated risk of the credit institution.

So incentives matter because they drive behaviour. Some recent bank failures are not caused by individual executives breaching regulation or internal rules, but by poor incentive frameworks that are misaligned with long-term health of banks.

Executives made risky decisions, allowed by the rules (of the time) and applauded by stockholders. They made judgements that of course could be right or wrong. So causing a bank to collapse will not necessarily lead to 'charges' of misconduct and some recklessness to blame as is the case with regards to former RBS executives or other bank executives elsewhere. Anyway, bankers can get judgement right and sometimes wrong. Could we procecute someone solely for poor business judgements? Most, if not all, of us would say no.

That said, banking is not like other sectors according to Adair Turner (Chairman of the FSA) in yesterday's Financial Times. In banking, "higher return for higher risks is also sometimes achieved not by socially valuable product innovation, but by leveraging up and taking liquidity risks....".

Besides the business of banks seems to become more complex and opaque around these crisis years compared non-banks, banks also have numerous and important stakeholders (not only shareholders and debtholders but also a.o. depositors, regulators, government as insurer of deposits and taxpayers in case they are too big too fail).

Furthermore, banks that the market favored in boom times, as bankers are encouraged to take on riskier activities, are found to have especially poor returns during the crisis (Beltratti and Stulz 2009).

Even a risk-adjusted remuneration scheme (see a methodological survey by BIS on this here) is still prone to moral hazard because of the fat-tail risk presented by bank failures. Regulators need to address this asymmetry in that bankers and shareholders get extra rewards (even being risk adjusted according RAROC metrics for instance), while the society should foot the bills to pay for failures of judgement.

Banking is indeed different from other sectors. Bank failures prove to be so costly and have caused sudden missery to ordinary citizens in Ireland, Iceland, etc.. - countries where the banking system is over sized and must be rescued by the tax money.

So let's get back to this serious theme and check if the incentive issue is on the agenda, especially when this is not a lively or popular issue in non-crisis countries like Indonesia.

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