Senior bankers make a lot of money and take a lot of risk. This combination strikes most commentators and politicians as revealing sad failures of personal morality and corporate governance, failures that must be rectified by the regulation of bankers’ pay. They are confused.
The principle challenge of corporate governance is to align the managers’ interests with the owners’. A simple way is to make managers owners too, by paying their bonuses in company shares. Yet this is an imperfect solution, because it fails to give managers the same “risk appetites” as other shareholders.
Few of a company’s shareholders are investors in that company alone; most hold a diversified portfolio of stocks. Provided these stocks are not perfectly correlated, the volatility of the portfolio’s value is lower than the average of each stock’s volatility. When held in such a portfolio, the optimal volatility of each individual stock is higher than it would be if held on its own.
The risks of company managers, by contrast, are concentrated in the firm they work for. Not only are they partly paid in its shares but, if the company fails, they lose their incomes. A company’s managers are therefore more risk averse than its owners, even when their bonuses are paid in shares.
This fact helps to explain the high salaries, huge bonuses, “golden parachutes” and other elements of “fat cat” compensation that outrage the popular press. They are designed to relieve corporate executives of their natural caution and bring their risk appetites up to the level of the other shareholders’. Contrary to popular opinion, it is low paid and risk-averse bank managers that would represent a failure of corporate governance.
But surely, some will protest, the financial crisis shows that bankers took too much risk. It does not. Shareholders of a limited liability company enjoy an asymmetric exposure to its performance. If it does well, there is no limit to how much their equity can appreciate. If the company fails, however, the most they can lose is what their shares cost to buy. This means that shareholders benefit from risk.
A simplified example will make this clear. Imagine you are a shareholder of a firm with a leverage ratio of 10:1. If the assets devalue by 10 per cent, you lose all your equity. However, if their value increases by 10 per cent, you double your money. If the probability of each outcome is 0.5, your equity is worth 1 (=2×0.5+0x0.5). Suppose the firm now increases its risk by taking its leverage to 50:1. If the assets increase in value by 10 per cent, then your equity is worth 6. If the assets decline in value by 10 per cent, then your equity is again worth nothing. The expected value of your equity is now 3. The extra risk has made you better off.
Why then do companies not increase their risk ad infinitum? The answer is that they are prevented from doing so by their creditors. Because a firm’s creditors do not participate in its profits, they gain nothing from its extra risk taking. On the contrary, the more risk the firm takes, the less likely its creditors will be repaid and, hence, the greater the “risk premium” they will charge for their lending. It is the increasing cost of borrowing that constrains corporate leverage and other risk taking.
This market mechanism breaks down, however, when the corporates concerned are banks, because lending to banks is made (almost) risk free by government guarantees. These guarantees are explicit in the case of “retail deposits” and unstated but dependable in the case of “wholesale” bank creditors.
Since 1988, 28 of the world’s largest 100 financial institutions have failed. This equates to a 1.3 per cent annual probability of default. Nevertheless, the top 100 banks have enjoyed an average credit rating of A+, which corresponds to a 0.05 per cent annual probability of default. This apparent anomaly is easily explained by the fact that in only two of these 28 cases of bank failure did the national government allow creditors to suffer losses.
By eliminating the normal “risk premium” on bank debt, government guarantees subsidize bank risk-taking. A bank that took so little risk that it was no more likely to default than the government could borrow at the same low rate of interest even without the guarantee. Its managers would effectively be rejecting the government’s offer of a subsidy. By contrast, the greater the risks taken by a bank, the greater the subsidy it extracts from the government guarantee.
If the virtue of senior bankers’ is still not clear, imagine two tobacco companies, Holy Weed and Noxious Weed, both eligible for government subsidies of tobacco production. Whereas the CEO of Noxious Weed accepts the subsidy, Holy Weed’s CEO rejects it. Who has been irresponsible?
Perhaps the CEO of Holy Weed has performed a public service, but that is irrelevant. He is not a public servant. He is responsible not for public welfare but for the welfare of his firm’s shareholders. Rejecting a subsidy would be a dereliction of that duty, since it would drive down the value of Holy Weed shares.
Similarly, a senior bank manager who refused to take government subsidized risks would be derelict in his duty to his shareholders. It should surprise no one that banks whose senior executives had the greatest shareholdings also took the greatest risks. The bankers who “brought the economy to its knees” were only doing their job.
As a financial engineer I fear for the future when I read ‘explanations’ of the crisis which are barely more than a thinly veiled diary of events, rather than an attempt at explaining the genuine causes of the collapse of the banking system. Reference to the US sub-prime debacle is a classic case of describing the ‘straw’ rather than asking why the camel’s back was so overloaded.
Without a basic understanding of the causes of the crisis how can our politicians, central bankers and regulators design and implement a credible cure?
This excellent piece explains the core failure – the unintended consequence of the array of state subsidies from which the UK’s big banks benefit has been to remove the market constraint that would have either prevented the crisis or resulted in far more modest consequences – orderly bank failures. That market constraint has typically been provided by lenders to, not shareholders in, banks.
I agree that subsidies create a moral hazard however I think that this is just one of the special privileges that banks enjoy. In my view, the key issue is the actual nature of modern Western banking which makes these state subsidies necessary. This nature being, of course, fractional reserves pyramided on top of a central bank system, combined with a fiat currency regime.
The current system stinks, and it is riddled with systemic dishonesty.
Because banks and governments alike benefit greatly from the inflation that they create within this fiat nightmare economy, they stick together like glue in protecting it. They lie, cheat and steal off ordinary people day in and day out, and tell us it is all for our benefit, and how credit is the lifeblood of the economy.
Genuine savings are the lifeblood of the economy, not borrowing from the future at an artificially reduced rate to waste on rubbish made on the other side of the world. The politicians and bankers supporting this system should be slung out of office, and prosecuted for this systemic fraud. The likelihood of this happening? Zero. We need a popular revolution against this corrupt and evil system; but so few people actually realise how they are being cheated that this is never likely to happen. All that we can hope for is that the system itself will collapse under the weight of its own folly.
I think it’s distracting to look at a bank’s managements corporate responsibility alone. Yes, they have the responsibility to do what’s best for their shareholders.
But, we can legitimately criticise them for taking on that responsibility knowing that by doing so they would be force to become a party to stealing from the public.
But, people will always become bank directors, no matter if it’s a moral occupation or not, so the issue is mute. The more important issue is how to remove the perverse incentives.
Well said, Current.
Employing slave labour would be immoral even if the government sanctioned it, and all your competitors were doing it. It is no defence to say that you represent your shareholders, not the slaves.
The difference between this and accepting taxpayer bailouts is simply a matter of degree.
We should expect people to abuse our rotten system, but we shouldn’t respect them for it.
“Senior Bankers”,aka employees, are paid to exercise their job skills.
What kind of skills? Essentially, patience and diligence: borrow short & lend long on good security. Not exciting, but profitable and probably what most shareholders and all depositiors expect. RBS ex-employees would likely endorse this.
“Senior Bankers” who relish risk and fancy titles should be operating speculative co-operataives (let us keep the word “banking” for the prudent use of depostors’savings) funded by people with the same risk appetite as themselves.
And concerning risk: is it just a maths proposition? Is there no room for judgement, for temperance, for seeking a just balance between folly and inertia? Saying that creditors are an adequate restraint on unlimited risk taking is like observing with complete satisfaction a lunatic being retrained by his carers, without pausing to enquire if the poor man might not be better off without his madness.
I am a little puzzled why nobody has pointed out that the ‘simple example’ is not simple at all and is plain wrong. Many years ago Modigliani and Miller explained why changing gearing does not improve shareholder value apart from tax effects. In the ‘simple example’ given you can see why by replacing the first case company which had
shares 10
debt 90
assets 100
with one that has
shares 1
debt 99 I can’t quite get 50:1
assets 100
Clearly the risk has skyrocketed so that a tiny drop in asset values wipes out the equity. The only way of getting to an increase in expected value is to shoehorn the example into only two outcomes with a 50:50 probability.
You’re quite right that if a larger number of probability buckets are introduced here then the result changes.
The point here though is that if the state are subsidising debt contracts then it is in the interest of banks to use them for funding.
Remember, what the Modigliani-Miller theory says is about the situation where you have self-interested lenders and shareholders. But, if the lenders don’t have normal interests -because of deposit insurance- then things are different.
See Arnold Kling’s post on this:
http://econlog.econlib.org/archives/2010/03/banks_and_modig.html