Major central banker says that banks should not link pay to equity return
11/11/2011
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There has been an influential call for banks to end their culture of linking remuneration to equity and look instead at returns on their total assets from Bank of England Executive Director for Financial Stability Andrew Haldane. Mr Haldane is also a member of the BOE’s newly formed Financial Policy Committee – which is steering the central bank’s policy to bolster financial stability.

Mr Haldane highlights the salaries paid to bank executives, and notes that when the financial crisis hit it was (British and US?) society as a whole that had to pick up the tab, showing bank gains were privatized but losses socialised. He identifies the link between pay and bank equity prices as one factor that distorted incentives for executives.

In 1989, the Chief Executive Officers of the seven largest banks in the US earned on average around 100 times median US household income. By 2007, at the height of the financial boom, their earnings were over 500 times median US household income.

Mr Haldane says banks should switch from linking pay to return on equity to linking it to return on assets – which would take into account banks’ whole balance sheets.

Mr Haldane is correct in saying that 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 significant.

Mr Haldane says had the CEOs of the seven largest US banks linked remuneration to ROA their pay by 2007 would have been just 68 times median household income.

There are, of course, downsides to Mr Haldane’s suggestion. For example, it would limit the scope for commercial banks to use product pricing as a means to compete and build up a loan book. The current Australian government and community seek this sort of competition. Mr Haldane’s suggestion could also limit a system stabilizer. That is, a company with a low ROE can more effectively employ a product pricing strategy to build its loan book and improve its ROE relative to other banks with high market share, higher ROE and less room to move on product price. In other words, it allows banks to compete for a better distribution of assets across the banking system. Arguably, this is better for an economy.

In addition, Guerdon Associates have found much better correlations between bank total shareholder return and ROE than ROA. So it is hard to see bank boards being persuaded to adopt an incentive measure less aligned to shareholder (versus bond holder) interests.

But Mr Haldane makes some valid points. As always, it is better not to be too prescriptive on how markets (including executive incentive plans) operate.

Mr Haldane’s speech is an interesting read – and can be found HERE

Meanwhile, on 4 November 2011, the Financial Stability Board (FSB) released its list of 29 global systematically important financial institutions.

Despite the obvious risks associated with these banks’ operations, most of these institutions have not appointed risk management experts to serve on their boards. Two-thirds of the companies on the FSB list have not appointed a single independent director who has significant risk management expertise. 
Furthermore, Sweden’s Nordea, France’s Credit Agricole and Societe General, Italy’s Unicredit, and all three Japanese banks have not appointed board committees tasked with overseeing risk management.

Given the extra obligations on these institutions the Australian business community should be thankful that no Australian bank is on the list.

The list can be found HERE.

© Guerdon Associates 2021
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