OECD Forum 2011.The fight to restore trust

It’s receding into the past, but the Great Recession – and the factors that led up to it – are still very much on attendees’ minds at the OECD 50th Anniversary Forum this week. At a session entitled “Restoring Trust in the System,” a wide range of opinions were heard on lessons for financial regulation and corporate governance in the wake of the crisis.

Seated side-by-side on the first panel were ministers from two countries that had very different experienceces in the crisis: Canada, which sailed through the recession and has come to be seen as a paragon for financial regulation, and Iceland, whose Finance Minister, Steingrímur J. Sigfússon, admitted that “we were not quite as lucky as Canada”.

Steingrímur managed to get to Paris despite the clouds of ash from the latest troublesome Icelandic volcano – “we picked an easier name this time,” he joked. That led him to draw comparisons between the forces of nature and the forces of the economic system: “When faced with forces of nature, we feel humbled,” he commented. With financial markets, we need a similar attitude, he said. We must realise the limits of what we know and don’t know, he said, and admit that things went wrong: “There were fundamental flaws in the system, otherwise this would not have happened,” he said. 

The Icelandic minister raised an issue that was echoed by a number of speakers – pay and compensation for bankers and executives: “Why do we accept that bankers need tremendous bonuses to do their jobs, but not surgeons saving people’s lives?” Steingrímur asked. The point was also raised by Peter Mandelson, a former EU Trade Commissioner and British government minister. “Executive pay has become disconnected from reality,” he said, citing a big increase in payments to British business leaders. In 1998, said Lord Mandelson, payments to executives at FTSE 100 firms were 47 times average earnings at their firms; since then, they’ve risen to a multiple of more than 100, far outrunning any improvement in the firms’ share price. While stressing that he didn’t believe in the politics of envy, he said the “scale of what has happened cannot be justified.”

 But Federico Ghizzoni, CEO of the Italian-based banking group UniCredit, defended his remuneration. He said there was a perception that everyone got huge bonuses, but this was not the case. On average, he said, after-tax salaries in Italian banks were only about 30,000 euros a year. He added that half his bonus was based on customer satisfaction and his company’s reputation, as measured by an independent survey. Still, he wasn’t complacent about the challenges facing banking: “The crisis of 2007 was a crisis of values,” he said, “if you don’t measure and test the values of your management, it will come back.”

Values were also on the mind of John Hope Bryant, founder of Operation Hope, which works to expand economic education and empowerment in the US. He said the crisis had shown the need to improve financial education: “This is a civil rights issue – if you don’t understand the language of finance today, you’re an economic slave.”  

Lord Mandelson warned about the risks to social stability from the after-effects of the crisis. Despite the enormous progress in OECD countries over the past 50 years, “the mood of our citizenry is not celebratory,” he warned. There was a lot of apprehension and scepticism about politicians and business, he said, and these attitudes were very corrosive. If left unchecked, he said, they would sap our capacity to make the decisions we need to make.

Echoing Lord Mandelson’s comments, Christine Varney, US Assistant Attorney General, Department of Justice, said there was an argument for a fundamental change in the attitudes of business. At present, boards were legally required to concern themselves only with increasing shareholder value. That approach may be too narrow, she said; she called instead for a focus on stakeholder value – in other words, the interests not just of a business’s shareholders but of its customers, suppliers, and the society in which it operates. David Begg, an Irish labour leader, went further, and said that the economy must be embedded in society, and not the other way round. “Until we achieve that,” he said, “there can be no possibility of restoring trust.”

Useful links

OECD: Strengthening governance, restoring trust  

OECD work on corporate governance

Banks, bonuses and Basel

It's hard to believe now, but in those days, you had to use your own money

Smoothing his comb-over to a rakish angle, Vinnie settled his beer gut on the bar and waited for the chicks to come running.

Not the most realistic introduction, I agree, but it’s less naïve than: “Realising that taxpayers would be paying for his greed and stupidity until the Universe started contracting again, the banker apologised sincerely and took steps to make sure it would never happen again”.

In fact, as the FT reports, during questioning by a UK parliamentary committee yesterday, Bob Diamond, Barclays’ chief executive, said the time for “remorse and apology” by banks over their role in the financial crisis should end.

That’s right, Bob, let’s try to achieve closure. The businesses that went bankrupt and people who shut the front door on their homes for the last time managed it, so why not the rest of us?

And if grief counselling doesn’t work, you can always retreat into a magic dream world and “make the issue of bonuses go away”. Bob certainly wishes he could, but when you examine his fantasy closely, it’s not as fluffy as it first sounds. It’s the “issue” (all that mean-spirited whinging) he’d like to go away, not the bonuses they pay each other.

The problem is, it’s impossible to stop paying bonuses without “severe consequences” for business and the banking sector. Let’s face it, the kind of talent capable of losing trillions of dollars and bringing the world financial system to the point of implosion in the space of a few days doesn’t come cheap.

It’s as if the crisis never happened, or if it did, that banks and bonuses had nothing to do with it. That’s not the conclusion reached  in 2009 by an OECD study on Corporate governance and the financial crisis: “An area of particular concern in financial firms is whether there is any risk adjustment in measuring performance for the purpose of bonuses”.

In case you’re not clear about what a lack of risk adjustment is, the report gives examples. For instance, despite losing $15 bn in the last quarter of 2008, Merrill Lynch paid out $4-5 bn in bonuses at the start of December before the taxpayer helped with the merger with Bank of America.

Lack of risk adjustment means that the traders and their bosses are more likely to focus on risky short-term schemes that could damage the firm. It also leads to firms overpaying their employees in comparison with their contribution to long-term value creation.

You’d think that proposals to reform the financial sector would deal comprehensively with risk, but as OECD’s Adrian Blundell-Wignall and Paul Atkinson of the Groupe d’Economie Mondiale de Sciences Po show in this paper, the so-called Basel III proposals do not properly address the most fundamental regulatory problem facing the system, namely that the “promises” to repay that make up any financial system are not treated equally.

Here’s what that could mean in practice. Bank A lends $1000 dollars to a company and the rules say it has to hold $80 in capital, so its leverage in this case is a relatively modest 12.5 ($1000 = $80 x 12.5). However, it can pass on the promise to redeem the loan to Bank B.

Bank A now has to cover the capital “weight” of this transaction. Since B is a bank, that weight is fixed at 20%, but not of the original $1000, only of the $80. So Bank A now only has to hold $16.

Bank B doesn’t have to carry the risk either, and can underwrite it with a reinsurance company entirely outside the banking system, and not subject to its rules.

The banks can reduce the capital required from $80 to under $20 and increase their leverage from 12.5 to over 50. Basel III wouldn’t stop this.

Blundell-Wignall and Atkinson conclude that if banks can shift promises outside the bank regulatory system, there’s a strong case for having a single regulator for the whole financial system – and global coordination.

Useful links

OECD work on financial markets

OECD work on corporate governance