Few world leaders have addressed the systemic issues underlying the global financial crises.  Within a broader speech to the UN General Assembly on 25 September, Australia’s Prime Minister, Kevin Rudd, took time to do just that.  Mr Rudd also provided a much clearer indication of how the Australian government would prefer banker pay to be regulated. 

The first indication that banker pay may be regulated was via our May newsletter (see HERE).  Even before this, we alerted readers that the government was going to regulate executive pay more generally (see HERE). 

Banker pay regulation also has characteristics that make specific country regulation problematic.  The typical banker pay structure that contributed to the crisis rewards bankers with a slice of the performance fee charged for investing other people’s money.  The problem was (and is) that the performance fee was based on the revaluation of assets, rather than the actual profit on realisation of assets.  As asset values spiraled so did banker pay.  But when asset values evaporated bankers did not have to give back their pay, and it was the punter left holding the parcel that wore the loss. 

At a private gathering of business leaders last Friday Mr. Rudd reinforced the perception that pay was not aligned with risk cycles when he said that the “disease” of short termism had infected governments and financial markets (see a report of the speech and interesting comments from others in The Australian HERE).

The problem is that the market for investment banker talent is global.  No one country could go it alone and insist that (for example) banker pay revert back to a long lost European model that deferred the incentive pay until asset values were realised because its banker talent would flee to the arms of grateful banking centres elsewhere in the world.  It follows that any solution would have to be global.  And this is what Mr. Rudd alluded to in his speech to the UN General Assembly, and again on Friday at a private function for business leaders.

Mr. Rudd suggested that the world act together to address the systemic issues that resulted in the current crisis.  But first he acknowledged that the immediate task is to rebuild confidence in the financial system, by ensuring that central banks provide adequate liquidity, by enabling the recapitalisation of critical financial institutions and by ensuring the continued solvency of these institutions. 

To address the systemic issues Mr. Rudd suggested five steps:

• First, systemically important financial institutions should be licensed to operate in major economies only under the condition that they make full disclosure and analysis of balance sheet and off-balance sheet exposures.
• Second, we need to ensure that banks and other financial institutions build up capital in good times as a buffer for bad times, using predictable rules.
• Third, financial institutions need to have clear incentives to promote responsible behaviour rather than unrestrained greed.
• Fourth, supervisory systems must be compatible with accounting principles that reflect reasonable assessments of the value of assets over time.
• And fifth, the IMF should be given a strengthened mandate for prudential analysis.

It was while addressing the third point that Mr. Rudd indicated how banker pay could be regulated.  Interestingly, it was not in a direct way, but addressed the implicit risk of misaligning the cycle and timing of investment returns with banker reward.  Specifically, he said:

“Regulators should set higher capital requirements for financial firms financial firms that have executive remuneration packages that reward short term returns or excessive risk taking.

And again the Basel rules also need to address this.”

This approach is consistent with that advocated by the UK Chancellor, Alistair Darling, just a few days previously.  The UK Financial Services Authority has indicated it will require financial institutions to put more capital aside if it believes their pay arrangements create additional risks.

Obviously Mr. Rudd’s comments raise many questions in relation to the method, disclosure, enforcement, consistency, validity, reliability and fairness.  But at least it answers two questions:

• Australia will not go it alone on banker pay regulation
• Any regulation is unlikely to happen in the short term

The full text of Mr. Rudd’s speech to the UN can be found HERE.

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