Bank of England official calls for radical overhaul of bankers’ pay

Andy Haldane says remuneration should be linked to return on assets rather than equity, making banks bear more of the risk

Jill Treanor, City editor, Monday 24 October 2011 18.35 BST

Andy Haldane said ‘deep-rooted incentive problems in banking need to be tackled’

Bankers’ pay should be radically overhauled, according to one of the Bank of England’s most senior policymakers, who has called for a closer link between bonuses and the risks taken by banks.

Andy Haldane, the Bank of England’s executive director for financial stability, argued that if the performance of bankers had been measured against loans rather than share prices, there would have been a dramatic reduction in their pay levels in the past two decades.

Speaking in a personal capacity, he said “deep-rooted incentive problems in banking need to be tackled”. Analysing the pay of the chief executives of the biggest seven banks in the US, Haldane reckoned that the average pay had risen tenfold from $2.8m (£1.75m) in 1989 to $26m in 2007 because it was linked to return on equity (ROE). But if it been had based on the risks their banks took in granting loans, return on assets (ROA), their pay would have risen much more slowly – from an average $2.8m to $3.4m.

“If you believed ROE were a reliable performance metric, US bank CEOs would have had a watertight defence back in 2007. Indeed, it was the L’Oréal defence: because we’re worth it. But experience since suggests this performance was cosmetic,” he said.

Haldane, who is concerned about risks in the financial system and their wider impact on society, noted the “eye-popping” implicit guarantee to the UK banking system from taxpayers of $340bn per year – or $1.3tn globally – and said that while bankers have benefited from the risks they have taken, wider society is carrying the cost.

“In England and Wales alone, over half a million individuals and nearly 100,000 businesses have found themselves in insolvency since 2007. Internationally, a growing number of sovereign states face a similar fate. This tells us that the risks from banking have been widely spread socially. But the returns to bankers have been narrowly kept privately,” said Haldane.

“That risk/return imbalance has grown over the past century. Shareholder incentives lie at its heart. It is the ultimate irony that an asset calling itself equity could have contributed to such inequity. Righting that wrong needs investors, bankers and regulators to act on wonky risk-taking incentives at source,” he said.

The repercussions of the banking crisis are acutely felt by some elements of the population and prompted protesters to set up camp around the world, including outside St Paul’s Cathedral where the Occupy LSX protests are promising to stay until Christmas.

Haldane set out a detailed argument to measure performance against assets (loans in the case of banks) rather than equity, arguing that ROE “flattered returns, and hence compensation” during the good times because it puts risks ahead of long-term returns.

“It would be a relatively small step for banks to switch from ROE to ROA targets in their capital planning and compensation. Yet the effects on risk-taking and remuneration could be large,” he said.

It would have contained the rise in pay for bank chief executives in the US between 1989 and 2007. “Rather than rising to 500 times median US household income, it would have fallen to around 68 times,” he said.

Haldane noted that the way banks have raised money to operate – not just from shareholders but increasing from bondholders – has created a “governance fault line”. Shareholders have greater influence over management by voting at annual meetings, while bondholders do not. He suggests that this could be tackled by giving holders of a new type of bond – known as contingent capital, or cocos – votes, and even depositors. “Holders of cocos might have voting rights which were some fraction of their equity equivalents and depositors likewise,” he said.

He also noted bondholders had failed to recognise the risks building in the banking system. The cost of insuring banks against default on their debt – through credit default swaps – fell dramatically between 2002 and 2007. “Market perceptions of risk were falling at precisely the time risk in the system was building,” he added.

He again blames the “incentives” of banks’ management and the authorities who in times of crisis did not make bondholders bear risks. He also notes that this helps to perpetuate the “too big to fail” problem as banks that might expect a bailout are also able to borrow money cheaply

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