06 December 2007
Paul Myners on Moral Hazard in banking
Following my recent entry on the moral hazard in banking, I was very interested to read Paul Myners comments on a similar theme. These comments were made in a substantial interview reported on ft.com 4th December 2007.
The full interview can be found at (subscription maybe required):
http://www.ft.com/cms/s/0/7272fc1c-a28b-11dc-81c4-0000779fd2ac.html
Specifically on the moral hazard point Mr Myners said:
"I think there’s an inbuilt moral hazard in banking. I think that isn’t just confined to banking. I think it includes private equity and other forms of investment in which the incentives to take on risk in pursuit of reward are not symmetrical to the consequences of getting that wrong. So there’s a natural inclination to stay with risk for too long. Chuck Prince embraced this in his famous statement about the music’s still playing, but I think that’s true to some extent to equity investors as well. While the market is rising, it is better to stay in than to seek to anticipate a fall, get that wrong for a short period of time, underperform against an index and benchmark and other managers, and run the risk of losing the account. So, the economic rationality that should lie behind equity and other forms of investment, doesn’t always work in the way that the economist assumes because the economist has not factored in the agency risk for the agent underperforming against expectation."
It seems to me that the problem that Mr Myners describes is not so much "inbuilt" but rather a direct consequence of the way fund managers are paid and of performance being measured over too short a timescale.
If I had my own money invested in a market that was still rising, but expected to fall significantly at some point in the next year, then I would clearly be looking to sell [Interestingly I did move significant personal money out of equities in June 2007!].
Surely then if I employ a fund manager to look after my interests then the fund manager should also be looking to sell my assets for me in this scenario. But Mr Myners points out that this strategy does not work for the fund manager because, if the market continues to rise for several months then the funds performance will look poor over this period, and the fund manager will lose his bonuses.
[I do worry that American stock values are currently propped up by fund managers looking at each others behaviour and all desperately hoping that they can get through to year end without a big fall. Should we expect a big fall early in the new year?]
It seems top me that there are two possible ways round this problem:
1) Stop all performance related pay for fund managers. They could be paid a flat salary and encouraged to take seriously their fiduciary duty to the underlying owners of the assets.
or
2) Require all performance related pay for fund managers to be linked to long term (five years?) performance measures, using a structure similar to the FILLIP described in Performance and Reward.
Obviously it is important that the people who hire fund managers also restrict their attention to long term performance. If they move their money too often they undermine the long term thinking of the fund manager. Mr Myners comments about developing the expertise of Pension Fund Trustees are important in this respect. However it is important that any "professionalism" in pension fund trustees stops short of giving them a vested interest in outcomes, or does anything to undermine their duties to the underlying owners of the funds.
The full interview can be found at (subscription maybe required):
http://www.ft.com/cms/s/0/7272fc1c-a28b-11dc-81c4-0000779fd2ac.html
Specifically on the moral hazard point Mr Myners said:
"I think there’s an inbuilt moral hazard in banking. I think that isn’t just confined to banking. I think it includes private equity and other forms of investment in which the incentives to take on risk in pursuit of reward are not symmetrical to the consequences of getting that wrong. So there’s a natural inclination to stay with risk for too long. Chuck Prince embraced this in his famous statement about the music’s still playing, but I think that’s true to some extent to equity investors as well. While the market is rising, it is better to stay in than to seek to anticipate a fall, get that wrong for a short period of time, underperform against an index and benchmark and other managers, and run the risk of losing the account. So, the economic rationality that should lie behind equity and other forms of investment, doesn’t always work in the way that the economist assumes because the economist has not factored in the agency risk for the agent underperforming against expectation."
It seems to me that the problem that Mr Myners describes is not so much "inbuilt" but rather a direct consequence of the way fund managers are paid and of performance being measured over too short a timescale.
If I had my own money invested in a market that was still rising, but expected to fall significantly at some point in the next year, then I would clearly be looking to sell [Interestingly I did move significant personal money out of equities in June 2007!].
Surely then if I employ a fund manager to look after my interests then the fund manager should also be looking to sell my assets for me in this scenario. But Mr Myners points out that this strategy does not work for the fund manager because, if the market continues to rise for several months then the funds performance will look poor over this period, and the fund manager will lose his bonuses.
[I do worry that American stock values are currently propped up by fund managers looking at each others behaviour and all desperately hoping that they can get through to year end without a big fall. Should we expect a big fall early in the new year?]
It seems top me that there are two possible ways round this problem:
1) Stop all performance related pay for fund managers. They could be paid a flat salary and encouraged to take seriously their fiduciary duty to the underlying owners of the assets.
or
2) Require all performance related pay for fund managers to be linked to long term (five years?) performance measures, using a structure similar to the FILLIP described in Performance and Reward.
Obviously it is important that the people who hire fund managers also restrict their attention to long term performance. If they move their money too often they undermine the long term thinking of the fund manager. Mr Myners comments about developing the expertise of Pension Fund Trustees are important in this respect. However it is important that any "professionalism" in pension fund trustees stops short of giving them a vested interest in outcomes, or does anything to undermine their duties to the underlying owners of the funds.
Labels: fund management, incentives, moral hazard, Myner
