Tread carefully when it comes to reforming the banks

By John Plender Published: March 4 2009 02:00 Last updated: March 4 2009 02:00 As the state extends its creeping control over the banking system, the age-old problems of public ownership are back with a vengeance in the shape of muddled objectives, conflicts of interest and naked populism. In the US, the last-minute addition to President Obama's stimulus bill to impose draconian curbs on performance pay, while understandable, fails to address the real questions about incentive structures in banking. The UK government's angry response to the excessive pension payable to Sir Fred Goodwin after his disastrous tenure at Royal Bank of Scotland poses a worrying potential threat to property rights. In countries that have had housing bubbles, many politicians are keen to push banks into lending more to already over- indebted households when the priority should be for the banking system to support a rebalancing of the economy in favour of business while households pay down excessive debt. What is needed is a much more fundamental debate on banking governance. The first question to address is, what are banks for? After the catastrophe of the credit bubble, the suitability of the shareholder value model in banking is questionable. In effect, the banking system has been operating as an off-balance sheet vehicle of the public sector. In the good years, the bankers make a fortune through bonuses and stock options. In the ensuing bad years when many years' worth of profits are wiped out, the taxpayer picks up the bill for rescuing banks and other financial institutions that are too big to fail. The taxpayer is thus an important stake- holder in the banking system. The question is how to establish an accountability framework that reflects this reality. Perhaps it can only be done through tightening regulation and perhaps changing the legal definition of directors' duties in deposit-taking institutions. To have taxpayer representatives on bank boards would risk entr- enching a conflict of interest and undermining a collegial approach to decision making. Moreover, recent events suggest that too much faith has been placed in non-executive directors of banks. They failed in monitoring risk and presided over unbalanced incentive structures that encouraged excessive risk taking. The conventional wisdom about independent repre- sentation on boards may thus need overturning for complex financial institutions. More executi- ves and former executives may be needed to ensure there is proper understanding of risk and of the financial plumbing. There may be a case, too, for having the chief risk officer automatically represented on bank boards, or at least reporting directly to the board. There is also an urgent need to overhaul pay structures. This will not be easy because it is already clear that re-regulation will not be taking banks back to a 1960s-style simple utility model of banking. In an important speech in January, Lord Turner, chairman of the UK Financial Services Authority, said that while higher levels of capital would be needed, securitisation and the "originate and distribute" approach to bank lending would continue, albeit in a safer, more transparent form. It follows that big banks will continue to conduct complex treasury and market-making operations. That in turn means that rewards in banking need to reflect risk more closely. What urgently needs correcting is the heavy focus on a narrowly defined version of shareholder value that over-emphasises the share price and quarterly earnings numbers. This has been a disaster, encouraging shareholders to make excessive demands for smooth earnings growth. The preoccupation with return on equity has likewise been insidious because it encourages leverage and share buybacks that end up eroding bank capital. Such changes also require a different approach to accounting. Bonuses were inflated during the bubble by mark-to-market profits, which ratcheted up the euphoria. A less pro-cyclical accounting regime would be helpful. Whether it will be possible to move towards better constructed boards and risk-adjusted incentives within a largely state-controlled system remains moot. The risk is that reform of the governance architecture will be dictated by populist pressure, not considered deliberation. John Plender is an FT columnist and chairman of Quintain