Monday, 8 June 2015

It's About Time The 'Eat The Bankers' Myth Was Put To Bed

I don't know how many more times we have to keep hearing that the financial crisis was caused by bankers' reckless greed, and that the only recourse is to ramp up regulation in the financial industry. It is not untrue that greed played a part in the crisis, but it certainly is untrue that more regulation is the solution. The solution is, in fact, less regulation - and it was in no small part due to the fraught regulation in the first place that the bankers were encouraged to be so recklessly greedy. To explain why, let me offer you an analogy.

Suppose you have built up a successful ice cream shop over the past 20 years. Now you want to have a six month holiday and employ someone to run your shop for you for while you're away (let's call him Brian). How could you best pay Brian to ensure he keeps your shop profitable? You could pay him an hourly rate, say £8 per hour. But if he gets paid irrespective of sales he may slack off and lose some of your shop's vital customer service. Alternatively you could pay him by offering him a proportion of all the ice creams sold. This is more likely to make him work harder to increase your profits, but remember he's only there for six months so there's no guarantee that paying him in proportion to the goods he sells will give you long term profitability. For example, in trying to sell as much as he can short-term to maximise his earnings he may bulk-buy from a lower quality supplier, or he may neglect to do the weekly paperwork, or he may sell artificially low by over-working the ice cream generator even though it diminishes its functional life-span long term.

There are many things that would maximise Brian's profits short-term but be detrimental to the business long term. The best kind of Brian to employ would be a Brian whose desire to do what's best for your business correlates with what's best for him too. In other words, the best employees are those whose interests are closely matched to those of the employer.

In the financial industry this is an especially vital part of banking. Most of our politicians (in America and Europe) think that the financial crisis of 2008 confirmed once and for all that politicians need to regulate the heck out the banking industry. The regularly confused Owen Jones reminded us just last week that it was the greed of the bankers that wrecked our economy, and that more regulation is the only recourse.

Alas he fails to understand how the banking industry is driven by innovation of incentivising employees, rather like how the manufacturing industry is driven by innovation of new saleable products. The banking industry is complex, and risks are hard to decipher in prospect, which means that experimentation in competitive advantage is what drives money-making in banking. Over-regulation hinders this, which then goes on to create less stable banking. A key example of this is in State-guaranteed bail outs, which, as you might expect, increases risk instead of diminishing it. Of just under 30 banks that have failed in recent times, almost all of them were bailed out by governments. A banking industry that is guaranteed against failure by the government is going to increase risk not diminish it. If I go to a casino with the knowledge that I get to keep my winnings but a billionaire friend will reimburse me for all my losses, I'm going to be a pretty bold gambler that night.

The same is true with many bankers. If they perform well, there is not much of an upper ceiling regarding how much equity can grow for the shareholders. Losses on the other hand amount to only the cost of the shares. Shareholders interested in share prices are not averse to this kind of risk-taking. What quells risk-taking is creditor action in the form of risk premiums, which are charges for borrowing. It is because of government guarantees that creditors can lend to banks with artificially low risks, which, as you can imagine, distorts the market signals that would ordinarily keep bankers' behaviour in check. The huge irony that all the banker-blamers don't get is that distorting risk premium processes is, in effect, a State-funded subsidy on precarious risk-taking.

The other way that regulation is supposed to help is in quelling the detrimental outcomes associated with narrow short-term visions. Regulation mostly fails here too, largely due to the fact that senior bankers don't, in fact, have very narrow, short-term visions to begin with. A significant proportion of bankers' bonuses are commensurate with the share prices of the bank (they are paid either in shares or in cash), where those share prices are determined by forecasted profits. If a banker undertakes disproportionately risky deals to obtain short-term profits then the forecasts will likely predict much bigger losses in the future, which means share prices will immediately drop. Hence, managers paid in shares cannot afford to risk the narrow vision.

The banking risks that brought about the financial crisis were down to excessive gambling because the credit markets and stock markets didn't factor in those risks. Had this failure not happened banks would have seen a rise in the cost of capital and a drop in share prices much sooner, giving the natural incentive for bankers to reduce the risk voluntarily to maximise their variable pay. 

To see why the regulatory proposals will increase recklessness not decrease it, imagine we did go down the injudicious path of awarding variable pay when profitable ventures are completed instead of at the point of making them. It's pretty clear why that won't help things. Consider corporate lenders A and B who each lend out £1 million to 2 identical clients on a 4 year plan. With government regulations, any bonuses A and B procure on the deal should be deferred until the 4 year period is up, subject to the loans being fully paid off. If A's client defaults within that time period then most politicians think A should receive no variable pay. Here's the problem; how on earth can this improve A's decision-making? At the time of lending, the known risks presented by the 2 clients were factored in to the deal. It is a combination of varying factors way beyond the lender’s foresight that client 1 turns out to be one of the few that ends up defaulting. The risk is taken at the point of the loan, not at any time thereafter - so it is ludicrous to try to improve initial analyses by basing variable pay on unforeseeable future circumstances.

Such a proposal does not adjust risks, it adjusts unforeseen consequences - hence it is imprudent to evaluate financial restitution based on such factors, because it increases bankers' incentives to heighten risks. If they have to wait for the culmination of repayment you'll see a huge increase in risky deals because a great proportion of loan deals are low probability of high loss, so lenders might as well make more deals, particularly as the cost of huge losses won't be incurred by bankers' themselves but by bail-outs. The way to incentivise bankers to calculate the risk more diligently when making loans is to have them bear the cost of that risk at the time of making the decision by imposing a banker's insurance premium for the risk that that decision engenders (this is how banks insure using buffers for capital, where a premium for every loan can still be weighed).

Suppose the lender was paid variable pay equal to 10% of his contribution, where "contribution" means the interest margin he earns from the loan minus the premium charged to insure against the risk of the loan defaulting - the banker will have an incentive to only make the loan if the interest margin is greater than the cost of the risk-insurance. The bankers' role would be to calculate these loans using a risk analysis, and make the ones that seem economically viable, enjoying their bonuses on the profits, and bearing the costs on the losses. If you underestimate the risks then the insurance premiums will be too small, and there will be excessive lending - but this issue isn't solved by changing variable pay and bonuses, it is solved by improving the calibration of risks in the first place.

The impression created by many politicians and social commentators alike is that high-paid, big-gambling bank managers are the real failure of corporate governance. They are not - it is the other way around - it is low-paid, risk-averse bank managers that are failing the system. Firstly, managers tend to take fewer risks than shareholders (despite most people thinking the reverse is true), as most shareholders have diversity in stocks that are not correlated with each other, so all the eggs are not in one corporate basket. Managers on the other hand more often have all their managerial eggs in the basket of the company for whom they work, so if their company fails they'll lose their salary plus any company shares they own.

In a healthy system then, big bonuses, therefore, have the positive effect of increasing appetite for risk - which is a good thing because if risks pay off then appreciation of equity increases hugely, whereas if the risks don't pay off, the most the shareholders can lose is the value of the shares they bought (in other words, a few eggs in their basket). That is why shareholders benefit from risk, and why they want managers whose appetite for risk is voracious (the best way to achieve this is if when it comes to shares owned in companies managers have diverse portfolios). 

There are brakes in place to stop the risk culture going out of control and becoming a culture of recklessness, but they are not government regulatory brakes. What stops (or should stop) companies engaging in crazy lending is that a company's creditors (either a single investor or another company) have a claim on the services of the company taking risks, by providing something (a property or service) under the contractual agreement. As creditors don't share in the company's profits they don't gain from their company's risks - which is reflected in the risk premium agreed by the first and second parties (it is the increasing cost of borrowing that places constraints on corporate leverage and other risky ventures).

A mother would be foolish if she kept buying her young son lots of cakes and chocolate and then complained that he’d got fat. But if a boy wants lots of sugar he cannot be blamed for accepting his mother’s sweet subsidies. Similarly, a company's executive who rejects government subsidies does something irresponsible because he drives down the value of his company's shares. Given that a government's guarantee of bank deposits severely reduces the risk premium that banks must pay on their debt capital, it is clear that these kinds of bail-outs are unadvisable, and bad for the general public, who as taxpayers benefit much better when markets are left alone. When the government acts as a creditor they won't often demand higher interest rates commensurate with risk-taking, which is why it is better when non-government creditors incentivise against foolish risk-taking by reining in recklessness.

As I said earlier, government guarantees basically amount to a state-subsidised risk encouragement, by removing or depleting the standard market risk-taking discipline that creditors charge. Consider that bankers were not regulated 100 years ago, yet banks were still full of profit-seekers. Bankers will only make deals they think are profitable. But if depositors no longer benefit to the same extent by bankers' felicity, their incentive to look for prudence is diminished. When the government guarantees the losses of depositors, the depositors no longer have to monitor carefully whether the bank is a prudent lender. But as well, in such a culture, depositors are primed to favour riskier bankers, because higher risks increase the chances of higher rates of interest for their depositors in successes, whereas they only increase the chances of a government (i.e. taxpayers) bail out in failures. The government are the ones laying down a cushion for recklessness

On bonuses
One more final point, the bonus culture is not the financial bogey that so many people seem to think it is. If a bank can get away with apportioning some of the salaries in the form of bonuses, it is better than paying inflated salaries. That is to say, it would be a good idea to scrap bankers' salaries and get them to work on a bonus-only culture relative to their success. This is not alien to many bankers anyway; a great many have variable pay in shares, or in a bank bonus, contingent on the share price. These are reliable indicators because share prices are a good measure of a bank's performance - but the system probably needs tweaking to give greater incentive against failure.

Ask yourself this: which bankers are most likely to be attracted to such a pay structure? Fairly evidently it is bankers with the greatest ability to make lots of money for their bank. It is for that reason that the system of bankers selling their talents for pay-based rewards would work best. It's best for talented bankers with financial nous and business acumen, it's good for shareholders, and it's good for the economy too, as I explain in this blog post with the following analogy:

"Consider a car boot sale as an analogy. With car boot sales sellers pay a few pounds for a pitch because they expect to make more than the pitch fee in items sold. A car boot sale with a £5 pitch fee is pretty standard in the UK. If all prospective car boot sale sellers in the UK were suddenly hit with a mandatory £15 sellers' fee you'd find people with lower quality items would be less inclined to bother buying a pitch. Those with lots of quality goods might still be tempted, though, because they would have confidence that their net sales would exceed the £15 pitch cost. Charging a pitch fee, be it £5, £10, £15 or whatever is a great way to organise a car boot sale, because the fee, and the effort to drive down and set up, attracts only sellers who think they have enough quality items to sell and return a profit.

Imagine what would happen if, instead of charging for a pitch, car boot organisers started to pay people to set up stalls. There'd be recklessness, as sellers would turn up in their droves, pitching lower quality items safe in the knowledge that they'll make a bit of money anyway. Now apply that to bankers pitching for their own successes. Just as you don't need to pay car boot sellers with lots of quality goods to sell, you don't need to pay bankers with lots of business acumen and financial nous inflated salaries to perform well. To get them to make good decisions, you only need to give them share-based or bonus-based incentives to do what they do best, because their own wealth is tied up in their success. The banking system would be much better if bankers' bonuses were more, not less, and their salaries capped at zero - because increased bankers' bonuses would mean increased revenue for the bank as a result of prudent investments, or increased revenue for the bank as a result of overseeing a profitable merger for which they receive a percentage of the bank's often very large fee."