12 November 2007
Moral hazard, bank incentives and the credit crisis
In August, Mervyn King, Governor of the Bank of of England, made an important point about "Moral Hazard" which has not been taken nearly seriously enough. His point was that if the Bank of England helps banks that have taken imprudent risks then it encourages banks to take such risks in the future. Banks (perhaps imprudent banks?) complained that his stance was out of line with Europe and America and impractical. But now that the Bank of England has pragmatically made credit available there is a danger than Mervyn King's important point is forgotten about and lost.
The moral hazard problem on bank's behaviour stems from an even more important moral hazard problem in the way that bankers are paid. It is far too easy for bankers to get extremely rich on annual bonuses and other short term rewards, before the risks that they have taken properly come home to roost. When the risks finally do come home it is someone else (the banks shareholders, or public financial regulators) who carry the cost. Bonuses are not retrospectively deducted.
The problem is further exacerbated by the way that bankers are appointed or dismissed. Promotion decisions are influenced far more by personal performance in the last 18 months (before the risks taken have come to maturity) than on long term performance. Then when the risks go wrong the top man might lose his job, but he is paid handsomely for it! The message to potential future executives is clear - short termism pays both on the way up and on the way down.
To avoid moral hazard we need to take long term performance far more seriously than short term performance. In this context I was delighted to read Patrick Hosking's article in The Times, (10th November 2007, page 61, "Time to reform the way bankers are paid").
He is absolutely spot on to say that the way that pay works in the big investment banks is at the very heart of the current credit crisis. The incentives for senior bankers work over a time frame that is far too short.
As Patrick Hosking quite rightly says, shareholders should be demanding better practice on pay. But this is so obvious that I think we have to ask why it has not already happened.
I believe one reason is that shareholders are represented by fund managers and institutional shareholders who typically have exactly the same incentive problem in their own pay. They receive big incentives based on one year cycles, which are not aligned with the interests of the underlying owners of the funds. This is most clear in the case of hedge funds. A hedge fund typically charges very high fees for a good year of investment performance, but does not pay money back if the value of the fund falls. A investment strategy that makes good returns four years out of five, but which is occasionally disastrous, therefore works very well for the hedge fund manager, but not for the underlying owner of the fund.
We should be just as concerned about the way that fund managers are paid.
The book "Performance and Reward" (see link "View the book" in left hand column) suggests solutions to these problems. First of all, it sets out a form of executive pay called a FILLIP. A FILLIP depends on a far more rigorous alignment of pay with shareholders interests, such that performance for top executives is only about long term growth in shareholder value. It also, as Patrick Hosking's article suggests, holds performance related pay in a manner similar to an escrow account for, say, five years. This ensures that value lost latter in the risk cycle is properly reflected in the performance pay.
The moral hazard problem on bank's behaviour stems from an even more important moral hazard problem in the way that bankers are paid. It is far too easy for bankers to get extremely rich on annual bonuses and other short term rewards, before the risks that they have taken properly come home to roost. When the risks finally do come home it is someone else (the banks shareholders, or public financial regulators) who carry the cost. Bonuses are not retrospectively deducted.
The problem is further exacerbated by the way that bankers are appointed or dismissed. Promotion decisions are influenced far more by personal performance in the last 18 months (before the risks taken have come to maturity) than on long term performance. Then when the risks go wrong the top man might lose his job, but he is paid handsomely for it! The message to potential future executives is clear - short termism pays both on the way up and on the way down.
To avoid moral hazard we need to take long term performance far more seriously than short term performance. In this context I was delighted to read Patrick Hosking's article in The Times, (10th November 2007, page 61, "Time to reform the way bankers are paid").
He is absolutely spot on to say that the way that pay works in the big investment banks is at the very heart of the current credit crisis. The incentives for senior bankers work over a time frame that is far too short.
As Patrick Hosking quite rightly says, shareholders should be demanding better practice on pay. But this is so obvious that I think we have to ask why it has not already happened.
I believe one reason is that shareholders are represented by fund managers and institutional shareholders who typically have exactly the same incentive problem in their own pay. They receive big incentives based on one year cycles, which are not aligned with the interests of the underlying owners of the funds. This is most clear in the case of hedge funds. A hedge fund typically charges very high fees for a good year of investment performance, but does not pay money back if the value of the fund falls. A investment strategy that makes good returns four years out of five, but which is occasionally disastrous, therefore works very well for the hedge fund manager, but not for the underlying owner of the fund.
We should be just as concerned about the way that fund managers are paid.
The book "Performance and Reward" (see link "View the book" in left hand column) suggests solutions to these problems. First of all, it sets out a form of executive pay called a FILLIP. A FILLIP depends on a far more rigorous alignment of pay with shareholders interests, such that performance for top executives is only about long term growth in shareholder value. It also, as Patrick Hosking's article suggests, holds performance related pay in a manner similar to an escrow account for, say, five years. This ensures that value lost latter in the risk cycle is properly reflected in the performance pay.
Labels: Bank of England, long term, Mervyn King, moral hazard, Patrick Hosking, short term
