After the crisis: improving incentives in the financial sector

Excessive risk-taking, plausibly resulting from the deficient incentives facing the various stakeholders of financial institutions, is likely to have been a determinant of the latest financial crisis. The incentive problem is particularly apparent in the case of the institutions that are deemed too big to fail (TBTF). In order to restore incentives for balanced risk decisions and mitigate the implicit subsidy granted to TBTF institutions, several measures have been proposed. Important among these are higher capital requirements, including a capital surcharge for systemically relevant institutions, a fraction of this capital taking the form of contingent convertible bonds. Also of importance are organisational measures facilitating 'partial' bankruptcy and mitigating the externality imposed by systemically relevant institutions. The analysis shows that sound theoretical principles underlie these measures, which are part of the TBTF package currently submitted to the Swiss Parliament. It is argued that, beyond the intended reduction in risk-taking and the mitigation of the implicit state subsidy, these measures are likely to have few side-effects, either for lending practices or on the cost of capital. Return on equity will decrease in proportion to the decrease in the risks assumed by shareholders.

Part I: Risk and risk-taking
Progress in risk measurement: role in the crisis
There is no doubt that significant progress in both the definition and measurement of risk has been made in the recent past. As an example, the function of a risk manager was almost non-existent some 20 years ago. However, it is equally hard to dispute the fact that this progress has been over-estimated. For instance it was regularly claimed in the early 2000s that the financial system had never been as resilient and robust as it was at the time.

Part I: Risk and risk-taking
Progress in risk measurement: role in the crisis
There is no doubt that significant progress in both the definition and measurement of risk has been made in the recent past. As an example, the function of a risk manager was almost non-existent some 20 years ago. However, it is equally hard to dispute the fact that this progress has been over-estimated. For instance it was regularly claimed in the early 2000s that the financial system had never been as resilient and robust as it was at the time.

Risk and luck

Finance and banking are intimately linked with the notion of risk. Risk is a fascinating but difficult concept, if only because it is intimately linked with the concept of luck. In a risky world, heroes are more likely to be lucky than smart. In asset management, for instance, Barras, Scaillet and Wermers (2010) find that around 8% of mutual funds display a significant positive alpha, but of them only about 0.5% deliver a positive alpha that is not driven by luck. One question that arises from this finding is whether the associated statistics would be very different for the group of successful bank managers or successful traders in financial markets. Yet remuneration schemes do not appear to take this identification problem into account. It can be hypothesised that bonus payments are often a reward for luck rather than compensation for actual skill or effort. This hypothesis represents a very significant challenge for an efficient financial system. It is a challenge for a new school of finance. We need to improve our ability to distinguish between skill and luck. Simultaneously we need to draw the adequate conclusions from the difficulties that will always exist in signal extraction on this issue.

Excessive risk-taking: lack of knowledge...

Let me now turn to the question of financial risk-taking. Overall, there is no (expected) return and no growth without risk so we have to be careful to foster a sufficiently pro-risk society. But risk calculus – weighing the marginal advantages and disadvantages of taking more risk – is a difficult exercise. It is difficult because it entails probabilities, that are hard to assess, over future scenarios which are themselves often hard to describe fully and accurately. And the difficulty increases by an additional step if there is an externality, that is, if the private and social cost and benefit of additional risk-taking differ. One can plausibly argue that the recent financial crisis was, to some extent, the result of excessive risk-taking. For the proponents of this hypothesis, the ultimate cause is in question. One possibility is that this excessive risk-taking was the result of wrong incentives, with decision-makers wilfully taking more risk for themselves or their institutions than would have been privately or socially desirable. The alternative would be that a misperception of the probabilities and possible consequences of the decisions was the prime cause: a lack of knowledge or competence. Since I will essentially concentrate on the first possibility, i.e. incentives, let me recall, by a way of contrast, a recent study by Fahlenbrach and Stulz (2011). These authors show that the losses of the banks whose managers’ incentives were most closely aligned with the long-term interests of the firm they managed were at least as large, in the last crisis, as those at the financial institutions where governance was more obviously lacking. This suggests that wrong incentives were not the only factor in the behaviour and decisions that led to the crisis. Knowledge and competence were also at play.

... or a misalignment of incentives?

Incentives are an important component in risk and risk-taking. If there is an important lesson in economics and finance that has not been invalidated by the financial crisis, it is that incentives really do matter. The excessive risk-taking that was observed prior to the financial crisis is likely to have been – among other things – the result of the fact that key decision-makers were not provided with the right incentives to carefully analyse and balance the possible consequences of the risks they agreed to take. Let us take a bank as an example. The main relevant stakeholders are the depositors, the shareholders, the managers and the bondholders. What follows is a review of the situation of these stakeholders in relation to the desired risk profile of a typical bank.

Depositors
Deposit insurance ensures that it is not the business of depositors to worry about the amount of risk that the bank, in which he or she has deposited his money, decides to take. A key lesson of the Great Depression was that deposit insurance is a socially justified feature of the banking system. This follows from the fact that banks are institutions vulnerable to bank runs, no matter how well they are managed. The principle of deposit insurance is widely accepted and I will not further question it. Yet, the extent of deposit insurance and the form of its financing are important questions. Recent history has refocused our attention on these matters, but these are not the issues I would like to deal with today.

Shareholders
The incentives for shareholders differ from those of depositors. At first sight shareholders, as ultimate owners of the bank, can be counted on to discipline risk-taking by the institution they own. After all, they stand to lose their entire stake if the risks taken lead to bankruptcy. However, this is only true to a limited extent. Indeed, if we go beyond an initial, superficial consideration of the situation, we soon realise that shareholders cannot be expected to discipline risk-taking by a bank. There are a number of reasons for this. In addition to the fact that individual shareholders are often small and scattered, they only have limited ways of exerting pressure on management, short of disposing of their share. Importantly, the reality of limited liability seriously biases shareholders’ perspective on risk. While shareholders benefit from the upside of risk-taking, they are not symmetrically penalised on the downside. This asymmetry is particularly acute in the case of highly levered institutions. For these institutions, the return on equity in good times is high, say above 20%. The trade-off between high returns if the risky gamble pays off, and zero, if it does not, is particularly lopsided. Both limited liability and the natural highly leveraged nature of banking thus come with a natural propensity for socially excessive risk-taking on the part of banks’ owners. In this sense, shareholders cannot be relied upon to impose on managers the socially optimal level of risk-taking.

Managers
What about the bank’s managers? Here theory tells us that, apart from reputation and other soft considerations, the behaviour of managers will crucially depend on the link between their remuneration and the firm’s performance. What is at issue here is less the level of managerial remuneration. More important is the relationship between the remuneration and the medium to long-run performance of the bank. Clearly, a managerial remuneration scheme which depends exclusively on the bank’s current performance places managers in a situation similar to limited-liability shareholders. They cash in on lucky gambles but bear few of the negative consequences of unlucky ones. Unless we are willing to question the notion of limited liability for managers (as does Kotlikoff, 2010, for example), this kind of consideration provides the rationale for regulating managerial remuneration, and in particular for imposing long waiting periods before managers can cash in bonuses.5managerial payment structure is needed if we want to ensure that the risk decisions of self-interested
managers are in line with the long-term interest of firm owners and society.