The OECD’s Business and Finance Outlook looks at the Greatest Puzzle of Today

Business-Finance-Outlook-LaunchAdrian Blundell-Wignall, Director in the Directorate for Financial and Enterprise Affairs, Special Advisor to the Secretary-General on Financial Markets

The greatest puzzle today is that since the global crisis financial markets see so little risk, with asset prices rising everywhere in response to zero interest rates and quantitative easing, while companies that invest in the real economy appear to see so much more risk. What can be happening? The puzzle is even more perplexing when we see policy makers lamenting the lack of investment in advanced countries at a time when the world economy shows all of the characteristics of excess capacity: low inflation and falling general price levels in some advanced countries for the first time since the gold standard and despite six years of the easiest global monetary policy stance in history.

Will financial markets be proved wrong so that asset prices will soon collapse? Or, alternatively, will business investment take off and carry growth and employment to more acceptable levels validating the market optimism? The forthcoming OECD Business and Finance Outlook presents a reconciliation of these apparent contradictions based on the bringing together of new evidence about what is happening in some 10,000 of the world’s biggest listed companies as they participate in global value chains across 75 countries and which represent a third of world GDP. The salient points are these:

  • There is plenty of investment globally but from an advanced country perspective it is happening in the wrong places, as global value chains have broken down the links between policies conducted by governments inside their own borders and what their large global companies actually do. Short-termism too is apparent, where investors prefer companies that carry out more buybacks and dividends compared to those that embark on long-term investment strategies. Advanced country companies appear to prefer outsourcing investment risk to emerging market countries in global value chains when they can.
  • From a developing country point of view financial repression and exchange rate targeting are legitimate development strategies. Investment is enormous (running at double the rate per unit of sales in general industrial companies compared to those of advanced countries), but it is not well based on market signals and efficient value creation strategies. Instead, it is fostered by cross-border controls, the heavy presence of state-owned banks that intermediate the “bottled-up” savings into investment, local content requirements and pervasive regulations and controls. Over-investment—characterised as a falling return on equity in relation to the high cost of equity that opens a negative value creation gap—is a feature of many emerging market companies which, at the same time, are borrowing too heavily.
  • Concern about employment and growth in advanced countries has seen central banks vainly trying to stimulate investment at home: for six years they have kept close to zero interest rates and successive attempts at quantitative easing have been launched in the US, the UK, Japan and Europe. These actions are pushing up the value of risk assets in the search for yield, as pension funds and insurance companies face very real insolvency possibilities (with liabilities rising and maturing bonds being replaced by low-returning securities). The competition to buy high-yield bonds is seeing covenant protections falling, and less liquid alternative products hedged with derivatives are once more on the rise.
  • Many of these new products are evolving in what has come to be known as the “shadow banking sector”: as banks themselves have become subject to greater regulatory controls financial innovation and structural changes in business models are once again adjusting to shake off the efforts of regulators. Broker-dealers intermediate between cash -rich money funds on the one hand, which need to borrow higher-risk securities to do better than a “zero” return, and cash-poor institutional investors on the other, that need cash to meet margin and collateral management calls that the new-generation higher-yield alternative products demand. Shadow banking is focused on the reuse of assets and collateral. With this comes a new set of risks for financial market policy makers to worry about: leverage, liquidity, maturity transformation, re-investment and other risks outside of traditional banking system.

The Business and Finance Outlook provides evidence on some of these trends.

Nor are global value chains that facilitate the shift in the centre of gravity of world economic activity towards emerging markets serving economic development in the manner that might be expected.

Productivity of Sales versus Value Added in Advanced and Emerging Country Infrastructure & General Industrial CompaniesPrint

 Sales-per-employee, shown by the lines in the above graph, illustrate an astounding “catch-up” of emerging countries over the past decade. However, when company “value added” per employee is calculated (shown in the bars), there is much less sign of any emerging market catch up to advanced country productivity levels, in either infrastructure or general industrial companies.

Worse still, the “value added” productivity growth apparent in the rising columns prior to the crisis has not continued in subsequent years. This is no way in which to foster promises for ageing baby boomers, nor for the stable growth of employment for younger generations. The international financial and production systems will have to be reformed towards greater competition and openness if the world economy is to be put onto a more stable path.

Useful links

‌OECD Secretary-General Angel Gurría will present the findings in the Outlook at a launch event in Paris on 24 June 2015. This will be followed by a high-level roundtable debate on:

  • risks to the financial system in a low growth and low interest rate environment
  • whether pension funds and life insurers will be able to keep their promises

The event will be attended by representatives from the banking, insurance and pension fund sectors, senior pensions and insurance regulators, financial industry representatives, academics, journalists and other stakeholders.

OECD work on investment

OECD work on financial markets

Stimulating SME Equity Financing? Change The Culture

HPgarage1
Would you have invested in this SME?

On October 23rd, the OECD Financial Roundtable (FRT) dealt with public SME equity financing with a special focus on exchanges, platforms and players. In today’s post, Markus Schuller of Panthera Solutions gives us his personal view on the meeting.

Let’s face it: the bulk of small and medium-sized entreprises (SMEs) are still financed mainly by bank credit. However, as bank finance is harder to come by in the current post-crisis environment, fostering non-bank financing alternatives may help closing an SME financing gap. The OECD has been looking into such issues, also with input from the private sector via its Financial Roundtables. After the one held in April that discussed SME non-bank debt financing, this one, held in October, explored impediments and possibilities for public equity financing for SMEs.

Banks represented at the discussion naturally pleaded their cause, namely for debt financing, some even arguing that there is no shortage of SME debt financing, but only of risk financing. I allowed myself to add that this insight comes rather late. Too late actually, to stop the BoE and ECB in rolling out their securitisation support (asset backed securities purchase programme and covered bond purchase programme) that may be pointless if the analysis that the Eurozone suffers mainly from a demand-side problem is correct – as we have been highlighting over the last three years.

But back to the actual Roundtable topic. The overall challenge was described as how to stimulate equity financing for a segment that is characterised by low survival rates and a large diversity of entities, the two main drivers that make it difficult to assess risk. The focus of the debate was more on analysing the current drivers of a challenging environment for SME equity financing and less on solutions.

The limitations in the ecosystem (exchanges, platforms, brokers, market-makers, advisors, equity research) necessary both for the development of SME equity finance and the maintenance of liquidity in such markets can definitely be named as impediments. Having said that, those are technicalities that can be resolved quickly by market forces, given sufficient investor interest in allocating to this segment. It appears to be a chicken or egg situation, but it isn’t. If investors are intrinsically motivated to seeking exposure in SME equity investments, the supply side will follow.

Let me focus on a more fundamental driver of an investor´s motivation to ensure a sustainable flow in SME equity investments: cultural change.

In my FRT contribution I highlighted the lack of a risk equity culture across Europe as an important obstacle. In Germany, only 13,8% of the population invests directly (7,1%, 2013) or indirectly via funds (6,7%, 2013) in listed equity securities. Compared with around 50% in the US (45% in 2008, ICI Survey / 52% in 2014, Gallup Survey). Both the US and Germany saw a slight deterioration in equity ownership from 2000 until today, explained by the long-term effects of the dot-com bubble during the 2000s and the pro-cyclical behaviour of retail and institutional investors, leading to a reduction in their exposure caused by the Great Recession.

On top of shying away from the volatility in asset pricing, equity exposure in Germany is significantly linked to the educational attainment of the individual. In 2013, investors with vocational baccalaureate diplomas achieved an exposure of 25,9%, with secondary school leaving certificate only 11,8% and secondary modern school qualification alarmingly 6,5%.

How to reverse this trend of sinking equity ownership in Germany and neighbouring countries? By reframing the question. Let’s analyse what drove the rise of equity owners in Germany from 3,9 million (1992) to 6,2 million (2000) and back to 4,5 million (2013). Two main factors can be named for the rise: pro-equity friendly sentiment in politics; and accessible home bias led to a low entry barrier for investors.

The dot-com bubble burst deformed the first. Since then politicians harvest low hanging populist points by stigmatising equity markets as too dangerous to get exposed to. The Great Recession acted as reaffirmation of their convictions. Some even enacted policies to forcefully dry up market liquidity as seen in Austria with its stock exchange tax.

The dot-com bubble also caused millions of Germans to divest their home bias. Home bias is a well-researched cognitive dissonance in behavioural finance, driven by both rational and irrational factors. Local bias in SME investments is driven by pride of local ownership; ambiguity aversion (investors are more likely to choose an option with known risks over unknown risks, and with fewer unknown elements rather than many); identification with product, service or entrepreneur; reduced information asymmetry through local knowledge.

Sourcing information globally on listed companies works well thanks to its digital distribution, identifying yourself with them doesn’t. Investors reject exposure to risk if they cannot judge the situation, or do not know the relevant risk drivers. This behavioural pattern can be traced back to the individual’s need for control (as von Nitzsch points out).

The affinity to an equity home bias for both institutional and retail investors can be used as entry point for changing the lack of equity culture in Europe.

The same cultural change was needed in Europe for SME debt financing. For corporate debt markets it needed the Great Recession and banks unwilling to or incapable of lending to trigger the change. Since then, starting with large corporations, a trickle down effect is starting – see German “Mittelstandsanleihen” and their friendly welcome by investors. In short, cultural change is possible.

A potential trigger for cultural change in equity markets can be found in the ongoing financial repression and negative interest on savings accounts. Less a carrot, more a stick.

In my profession as asset allocation advisor, I cannot recommend a home-biased portfolio as being well diversified. Scientific evidence opposes this view. My point is to only use this bias as an entry point for inducing cultural change. It needs to be followed by a further increase in sophistication levels of market participants, enabling them to properly invest in a risk factor diversified, global, multi-asset portfolio.

Which leads to my second FRT contribution, namely on calling for increased education regarding equity investments for all market constituencies (SMEs, individual investors and advisors alike). Only increased levels of sophistication allow a responsible extension of alternative equity financing options in the ecosystem – see the delicate, little plant called “crowdinvesting” for example.

As cultural changes and educational effects only pay a dividend in the medium term, I suggested at the FRT to leverage the activities of an existing EU institution, namely the European Investment Fund (EIF).

It acts under the umbrella of the European Investment Bank (EIB). The EIF is a specialist provider of risk finance to benefit SMEs across Europe, including equity financing via more than 350 privately managed private equity funds. Its equity activity encompasses the main stages of SME development. In total it runs a book of EUR 5.6 billion in outstanding commitments, leveraging EUR 20,7 billion from other investors. In 2013, the EIF committed EUR 1.5 billion to mobilize EUR 7.1 billion in other resources.

In its announcement of a EUR 300 billion stimulus package for EU28, the Juncker commission should increase the EIF allocation power by a multiple. Positive real economic effects are guaranteed.

Useful links

OECD work on financial markets

Financial Market Trends OECD Journal

In my view: The OECD must take charge of promoting long-term investment in developing country infrastructure

LogoReDefine3Today’s post from Sony Kapoor, Managing Director, Re-Define International Think Tank, is one in a series of ‘In my view’ pieces written by prominent authors on issues covered in the Development Co-operation Report 2014: Mobilising resources for sustainable development.

The world of investment faces two major problems.

Problem one is the scarcity – in large swathes of the developing world – of capital in general, and of money for infrastructure investments in particular. Poor infrastructure holds back development, reduces growth potential and imposes additional costs, in particular for the poor who lack access to energy, water, sanitation and transport.

Problem two is the sclerotic, even negative rate of return on listed bonds and equities in many OECD economies. The concentration of the portfolios of many long-term investors in such listed securities also exposes them to high levels of systemic – often hidden – risk.

Most long-term investors would readily buy up chunks of portfolios of infrastructure assets in non-OECD countries to benefit from the significantly higher rate of return over the long term, and to diversify their investments. At the same time, developing economies, where neither governments nor private domestic markets have the capacity and depth to fill the long-term funding gap, are hungry for such capital.

So what’s stopping these investments?

Financial risks in developing countries are well known and often assumed to be much higher than in OECD economies. Also, investing in infrastructure means that investors will find it hard to pull their money out on short notice, and therefore such investments pose liquidity risks.

Despite these easy answers, however, there are three significant caveats:

First, the events of the past few years have demonstrated that on average, political risk and policy uncertainty in developing countries as a whole have fallen, especially in the emerging economies.

Second, OECD economies are also exposed to serious risk factors, such as high levels of indebtedness and demographic decline. As the financial crisis demonstrated, they are also likely to face other “hidden” systemic risks not captured by commonly used risk models and measures.

Third, the kind of risks that dominate in developing countries, such as liquidity risks, may not be real risks for long-term investors (e.g. insurers or sovereign wealth funds). Given that the present portfolios of these investors are dominated by OECD-country investments, any new investments in the developing world may look more attractive and may actually offer a reduction of risk at the portfolio level.

So I ask again: Why aren’t long-term investors investing in developing country infrastructure in a big way?

The biggest constraint is the absence of well-diversified portfolios of infrastructure projects and the fact that no single investor has the financial or operational capacity to develop these. Direct infrastructure investment, particularly in developing countries, is a resource-intensive process.

The G20, together with the OECD and other multilateral institutions such as the World Bank, can facilitate the development of a diversified project pipeline on the one hand, together with mechanisms to ease the participation of long-term investors on the other. This work will involve challenges of co-ordination, more than commitments of scarce public funds.

In my view, the OECD – which uniquely houses financial, development, infrastructure and environmental expertise under one roof – must take charge.

Useful links

OECD work on institutional investors and long-term investment

OECD work on financial markets

Better Plays for Better Lives: The Merchant of Venice

Giddy Fortune’s furious fickle wheel
Giddy Fortune’s furious fickle wheel

Today we publish the second of a summer series in which Kimberley Botwright of the OECD Public Affairs and Communications Directorate looks at OECD work through a Shakespearean lens.

Sixteenth century Venice was a global centre of merchant capitalism, and The Merchant of Venice offers an excellent examination of  human behaviour and its effects on financial markets. The point of this article is not to dwell on the appalling anti-Semitism of the period, but rather on the story of the hapless eponymous character and his reckless friend.

With the majority of his wealth at sea, Antonio uses credit to leverage capital to lend to his friend Bassanio (“Try what my credit can in Venice do”). Bassanio requires funding to seduce the wealthy heiress Portia. On Bassanio’s behalf, Antonio borrows 3,000 ducats for a three-month period from Shylock, who offers a 0% interest rate but takes the promise of one pound (around half a kilo) of Antonio’s flesh as collateral.

By Act 3, the audience discovers that Antonio’s ships have sunk, leading to a catastrophic devaluation of his net worth. To redeem his losses, he must pay the gruesome corporeal price under the terms of a notarized contract:

“Hath all his ventures failed? What, not one hit?  From Tripolis, from Mexico and England, / From Lisbon, Barbary and India? And not one vessel scape the dreadful touch of merchant-marring rocks?”

Antonio is significantly over-leveraged and he overconfidently manages risk, based on an uncritical acceptance of the present.  If only he’d read the OECD’s Future Global Shocks: Improving Risk Governance! He would have learned that disruptive events, such as a cargo ship sinking, can destabilise critical supply systems and have far-reaching economic effects.

He might also have learnt something about financial crises: “Arguably, financial crises both occur more frequently and produce more severe monetary damage than other types of risks described. There is a concern that the tools for risk analysis have not worked as well.” It goes on to emphasise that financial crises involve human, non-malicious choices and their re-occurrence should encourage us to search for new approaches to economic challenges and models “that use data on how agents actually behave.”

Bassanio provides an illustration of the erratic behaviour of individuals in financial markets. His justification for borrowing money from Antonio is based on the logic that if one shoots and loses an arrow, one should promptly shoot another in the same direction, in order to find out where the first went – not the most rational of approaches, seeing as it is very likely your second arrow will go the same way as the first. In short, Bassanio throws good money after bad.

Since the financial crisis, traditional economic models have become increasingly criticised for being blind to herd behaviour, network effects or information asymmetries and irrational action. Agent-based models (ABM) provide an alternative modelling approach. They focus on possible interactions between agents according to certain behaviour rules, running millions of simulations to approximate the millions of potential interactions between actors, gaining a better insight into possible outcomes of the complex system. In complex systems such as debt markets or financial institutions, shocks can be caused by external pressures (ships sinking) or internal (erratic individuals).  It is therefore important to understand these systems at both the macro and micro-level.

Another important human aspect of financial systems is trust and expectations. Towards the end of the play, Antonio is dragged to court, with Shylock demanding his pound of flesh. While the presiding Duke of Venice initially proposes that Shylock might assume certain losses and forgive part of Antonio’s debt, “Forgive a moiety of the principal, / Glancing an eye of pity on his losses”, this raises deep concerns:

“It must not be; there is no power in Venice
Can alter a decree established.
‘Twill be recorded for a precedent,
And many an error by the same example
Will rush into the state. It cannot be.”

A major fall-out of the financial crisis was the possible creation of “moral hazard”, the expectation, or guarantee, that public authorities will bail out uninsured and unsecured creditors of systemically important bank debt. When such guarantees are perceived, behaviour incentives may be distorted.

As two OECD papers on implicit guarantees and banking in a challenging environment make clear, solutions for our modern day financial dilemmas lie in internationally coordinated responses. For example, the first paper suggests that an effective cross-border EU bank failure resolution network would lower the value (and danger) of implicit sovereign guarantees. The second notes that as banks deleverage and assets become renationalised, a European Banking Union would sever the link between weak sovereigns and weak banks.

But knowing what to do and doing it are two different things, as the quick-witted heiress Portia reminds us; “If to do were as easy as to know what were good to do…”

Further reading:

OECD work on financial markets

OECD Journal: Financial Market Trends

Economic models used by the OECD

Bad, boring or bonkers? Science and policy making

Ahoy there, matey. How can we help?

France fought to get the “exception culturelle” recognised by the GATT,  the forerunner of the World Trade Organization, in particular to protect its own cinema against Hollywood. So it’s all the weirder that French movie distributors insist on translating titles from English into er, English. Wild Things, for instance, becomes Sex Crimes. It’s even weirder when the original uses a word of French origin in the title. Triage with Colin Farrell becomes, for French audiences, Eyes of War. However, the French are not alone, as I learned on reading this article by Quentin Cooper on the BBC website. Quentin wonders why the latest Aardman film The Pirates! In an Adventure with Scientists has been rebranded as The Pirates! Band of Misfits in the US.

The quick answer is that to many people, the subtitles are synonymous, and this isn’t surprising given the way science and scientists are often presented. You either get a man in a white lab coat staring intelligently at some exotic glassware full of scientific-looking liquid, or a wild-haired eccentric solving mile-long equations but incapable of posting a letter.

Scientific issues are regularly sensationalised, trivialised, or misunderstood by the media, with basically three types of story: breakthrough, silly or scare. Scare stories give a poor image of science, reinforcing the stereotype of the mad scientist whose research is dangerous for human health or the environment, with “Frankenstein” being used to label practically any product of genetic research for instance, even ants.

Trivia such as the scientific formula for how to make toast or write a sitcom present scientists as eccentrics and their research as futile.

Breakthrough stories give an image that is positive, but just as inaccurate as scares and trivia, ignoring the way ideas and intuitions emerge, are formulated as hypotheses and then tested, vindicated, revised or rejected over a period of time. Look at any health breakthrough article and if the full story is given, chances are that the researchers have come up with something that will take years to influence treatment, if it ever does.

At the same time, scientists must take their share of the blame too. Ananyo Bhattacharya, chief online editor of Nature argues here that if reporters wrote stories the way some scientists seem to want, few people would read science coverage. Both sides have to make an effort because an understanding of science and technology is necessary not only for those whose career depends on it directly, but also for any citizen who wishes to make informed choices about controversial issues ranging from stem cell research to global warming to genetically modified organisms to teaching the theory of evolution in schools. And new issues are bound to emerge in the years to come.

But could science do more than provide the knowledge needed to understand natural processes? A symposium organised by the Global Science Forum (GSF) at the OECD today explores new science-based tools for anticipating and responding to global crises. The premise is that new types of scientific inquiry, and new modes of science-policy interactions, are emerging based on the ability of researchers to analyse and to make reliable forecasts about policy-relevant phenomena that have, until now, been seen as lying outside the scope of useful scientific analysis.

Typically, these are systems and networks consisting of vast numbers of individual elements that interact in complicated ways, such as ecosystems, financial markets, energy networks, or societal phenomena such as urbanisation and migration.

In one sense, the symposium will simply be trying to bring policy makers up to date with developments since the last time they adopted a new set of scientific tools in the 19th century. The social sciences that now form a natural part of government decision making were only emerging, and borrowed much of their metaphors and terminology from the existing sciences, especially physics.

We still talk about flows, masses, equilibrium and so on (there’s actually something called a “gravity model” of trade, for example). But these terms are rooted in “classical” physics, developed before relativity and quantum theory. The GSF has been working for several years now to show how the new sciences of complexity can provide insights into systems that operate not just as series of actions and reactions, but with feedback, non-linearity, tipping points, singularities and so on.

We’ll report back on tools for anticipating and responding to global crises once the summary of today’s symposium is available. In the meantime, we laugh in the face of danger!

Useful links

Global Science Forum:  “Applications of Complexity Science For Public Policy: New Tools for Finding Unanticipated Consequences and Unrealized Opportunities

Future Global Shocks: Improving Risk Govenance

The symposium marks the 20th anniversary of the Global Science Forum and the 100th meeting of the OECD Committee for Scientific and Technological Policy

Geomagnetic storms: the fire next time?

5... 4... 3... 2... 1...

The Millennium Bug was a great disappointment to me. While everybody else drunkenly counted down the seconds separating 1999 from 2000, I froze in patient greed at an ATM waiting for it to start spitting banknotes into my waiting bag. It didn’t happen, and none of the other celebrations we’d been promised materialised either. Air traffic stayed controlled, life support systems went on supporting life, and even lifts went on lifting.

Still, the verified reports of Y2K incidents did show how dependent we’ve become on technology. In the most serious case, slot machines at a racetrack in Delaware stopped working, forcing gamblers to give their money to the bookies directly.

But what if the world’s electronic systems really did get seriously damaged? This year’s annual meeting of the American Association for the Advancement of Science had a session called Space Weather: The Next Big Solar Storm Could Be a Global Katrina. Space weather could affect a surprising range of activities. Anything using a satellite, obviously, but that includes a load of things that aren’t so obvious. For example, those ATM machines and many other credit card devices rely on spaceborne communications networks to interrogate your bank.

The OECD’s Future Global Shocks project looks at these issues in a new study on geomagnetic storms. The most powerful storms ever recorded were during the Carrington Event in 1859 (named after the amateur astronomer who recorded the solar outburst). The only important electrical infrastructures at that time were the telegraph networks. In some cases, operators could disconnect their batteries and continue sending messages using current generated by the storms, but the storms also caused outages.  

If a storm similar to the Carrington ones happened today, the costs would be enormous. In 2009, the US House Homeland Security Committee heard that: “The impacts could persist for multiple years with the potential of significant societal impacts; in addition the economic costs could be measured in the several trillion dollars per year range and could pose the risk of the largest natural disaster that could affect the United States.”

At the AAAS meeting, Sir John Beddington, the UK government’s chief scientist, put the bill at a more modest $2 trillion and warned that the potential vulnerability of our systems has increased dramatically.

On Tuesday of this week, a storm brushed the Earth provoking spectacular displays in the northern night sky, but the China Meteorological Administration reported that the solar flare also caused “sudden ionospheric disturbances” and jammed shortwave radio communications in the southern part of the country.

The space weather forecast isn’t great. We’re enjoying a calm period in the 11-year solar cycle just now, but it’s coming to an end, so hold on to your hat in 2013.

Useful links

OECD Project on Future Global Shocks

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