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Banks, bonuses and Basel

12 January 2011
by Patrick Love

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

One Response leave one →
  1. Baye Kambui permalink
    January 12, 2011

    And this is why we will have another crash. And another…

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