"Our submission to the Walker Review
Sir David Walker has been asked by the Chancellor to lead a review of corporate governance in the banking and finance sector.
Interested readers are very welcome to download a copy of the document:
Download Walker Review submission
It's a little more dry and technical in tone than some postings here, but is intended to be quite readable. Your feedback would be welcome."
"A submission to the Walker Review
Sam Robbins and Leigh Caldwell, Intellectual Business
30th May 2009
Intellectual Business is a think tank promoting innovative solutions to business and financial
problems. Its research combines economics, psychology, theory of business and law, and an
understanding of public policy, to build models of how people work and trade together – an
economics based on realistic psychological models and their macro consequences.
Sam Robbins is a former Executive Director of the Equities Division of UBS Investment Bank, London.
He has over ten years experience of financial markets, having worked first as a quantitative analyst
and later as a senior derivatives trader. He has a BA in Mathematics from the University of
Cambridge and an MSc in Government, Policy and Politics, from Birkbeck, University of London.
Leigh Caldwell is founder and director of Intellectual Business. He is also chief executive of Inon, a
technology and economics consultancy founded in 1995 and focused on applying behavioural
economics using Web technology. He has written for VoxEU on behavioural economics and financial
regulation, and has a BSc (Hons) in Mathematics and Physics from the University of Glasgow.
Intellectual Business
23 Jacob Street
London
SE1 2BG
020 7064 6556
http://www.intellectualbusiness.org/
Introduction
In examining corporate governance of financial companies, it is reasonable to ask: why do the
normal incentives of ownership not encourage appropriate behaviour? Shareholders of banks should
be able to discipline excessive risk-taking and encourage high long-term returns, and competitive
market discipline should ensure the optimal social return to financial activities.
In this submission we will argue that there are two main reasons why this does not occur.
The first is that the externalities of the financial sector are not priced correctly. Specifically, limited
liability for shareholders means that they do not bear the full cost of the risks they take; and the
short-term incentives for financial institutions do not reward the long-term return to investment,
which discourages it from taking place. Furthermore, we argue that bank boards did not deviate
from the wishes of their shareholders (prior to the recent crisis) but reflected exactly their revealed
preferences for excessive risk.
The second is that shareholders and other financial market participants are subject to bounded
rationality. There are limits on the information they can process, so they do not make fully informed
decisions and can be taken advantage of by better-informed insiders; and they are subject to
systematic cognitive biases which can distort behaviour and diminish long-term returns.
We explore those problems in further detail below, and then present potential solutions.
Externalities: Limited liability
In this section we argue that the ownership of UK banks by large numbers of small shareholders
contributed to the culture of excessive short-term risk-taking that existed prior to 2007. A
shareholder’s limited liability creates an incentive for them to demand excessive amounts of
leverage, which would not be demanded if they were exposed to the downside this engenders.
Whereas in other industries this pressure towards excessive risk taking is counterbalanced by the
existence of creditors’ desire to protect their investments, we argue that large banks encountered
less resistance from their creditors, because of depositor guarantees and a sector-wide interest in
preserving the status quo. This led to the running down of capital ratios and the increased exposure
of the sector to systemic risk. We will also argue that, though the structure of bankers’ remuneration
did lead to excessive long-term risk-taking for short-term gain, this culture evolved to satisfy the
preferences of shareholders, and any solution to the problem of excessive risk-taking must therefore
encompass how banks are owned as well as how they are managed.
The larger UK retail banks are typically owned by large numbers of small shareholders. Our
experience in the financial sector suggests that investors’ collective behaviour, prior to 2007, was to
actively target the banks offering maximum returns on investment, without any particular attention
to the risks involved. Investors would routinely target returns on equity as high as 20% and punish
stocks which did not achieve such exaggerated rates of return. We argue that banks and other
financial institutions increased their leverage as a response to this demand. Shareholders rationally
demanded this extra risk be taken, because their limited liability meant that, whilst their downside
was strictly capped at the level of their investment, their upside exposure could effectively be
multiplied through the process of leveraging.
Although the limited liability of shareholders creates the potential demand for excessive risk-taking
in any company, we argue that in most cases this is not realised because of the countervailing power
of their creditors. Banks are an exception to this rule, as they have considerable power to determine
how leveraged they are. Firstly, small depositors, who provide a significant fraction of all the
liabilities on a bank’s balance sheet, are widely covered by the Financial Services Compensation
Scheme, and so have a reduced incentive to scrutinise the bank’s financial health. Secondly, banks
often lend to other banks, who share an incentive to maximise their lending. Finally, regulators have
been historically weak in maintaining rules on capital ratios, in the face of an industry equipped with
large amounts of expertise in risk management. These factors combined to permit a situation in
which bankers, acting on behalf of their shareholders, took (and were able to take) excessive risks.
Bankers’ remuneration packages evolved to fulfil the needs of shareholders. Whilst much recent
commentary has revolved around the incorrectness of the incentive structures this created, we
argue that this was epiphenomenal, and ultimately caused by shareholder preferences. Shareholders
of banks consistently voted for the remuneration packages that were put in front of them. Longer
term remuneration packages (with “clawback” provisions for poor performance in later years) were
not previously implemented, as shareholders were not prepared to accept the possible loss of
personnel (and damage to shorter term returns) that would have resulted. Put another way, they
shared both the investment horizon and the moral hazard of the bankers they employed – counter
to the common perception that a principal-agency problem caused risk-taking distortions. We argue
that a change in the ownership structure of a bank, and a consequent change of risk preference,
would contribute to resolving the issue of banker remuneration, at the same time as resolving the
problem of excessive risk-taking.
Externalities: Is the finance sector acting in the interests of industry?
For public welfare to be maximised, individuals and firms together need to be able to choose the mix
of consumption, savings, borrowing and investment that is right for them over the long term.
The finance sector is the essential intermediary in this choice and in particular, it has a role in
delivering the appropriate amount of capital for investment in future productivity.
There is room for debate about the correct level and form of that investment, but at present it
appears that productive investment in the UK economy is running at levels below what is desired by
citizens. That the investment level may be less than its long-term average is not in itself a problem -
the choice made by consumers between current and deferred consumption may simply be different
to the choice made in previous decades. But if the level of investment that consumers wish to make
is not being achieved because of perverse incentives or behaviour within the finance sector, that is a
problem with major long-term costs.
Are the financial markets, then, underproviding capital for productive investment? We argue that
they are. The bias towards short-term returns and the nature of governance and reward structures
in the finance sector make it harder for banks and institutions to extend long-term lending to
corporates. In the short term this permits increased consumption but in the long term it will result in
slower growth and reduced living standards. Business investment figures1 suggest that UK
investment has historically been, and remains, lower than that in most other countries.
1 See for example http://www.bankofengland.co.uk/publications/speeches/2006/speech282.pdf, a speech by
Sir John Gieve, for discussion and sources
Bounded rationality: Cognitive bounds of small (and large) shareholders
A model where a complex company is owned by a large and diverse group of shareholders will
always suffer from problems of both information asymmetry and bounded cognition.
Rational ignorance
Bounded cognition of small shareholders (especially individuals, but also fund managers) creates
problems of misaligned incentives or “rational ignorance”. While better known as a problem in
public choice economics, rational ignorance is of critical importance in corporate governance too.
The problem can be summarised as follows: the cost to a small shareholder of carrying out proper
due diligence on a company, or even spending time to understand what it does, far outweighs any
possible benefit. An individual who holds £2,000 of RBS shares might need to spend weeks educating
herself to understand even a small part of the risks the company is taking, the likely future path of
the credit markets it is involved in, and so on. But the cost of that investigation will be several
thousand pounds in the investor’s time alone. The maximum possible benefit she can achieve is to
save their £2,000 investment by selling the shares before the company collapses, and so a simple
cost-benefit analysis says that she should not bother investing the time to learn about the
investment she is making.
The problem for larger investors is similar though at a different level. A fund manager holding £100
million of RBS shares can be expected to have carried out a certain level of research into the
financial sector and the risks their shares are exposed to. But to carry out proper due diligence on
their investment – of the kind that any venture capitalist would carry out on a startup they are
investing in – would be so expensive for a company of RBS’s size that it would outweigh any likely
benefit. A likely cost running into millions of pounds could in theory be recouped if the share price
were to move by a couple of percent, but the incentives within the fund management structure are
likely to make this cost prohibitive. The fund manager is unlikely to have the freedom to spend his
investors’ money on such investigations, and thus they would have to cover it from their own fees –
which will never be high enough to make it worthwhile, even if the value of the investment were to
move by as much as 50%.
While large private equity investors and hedge funds might have sufficient incentives to carry out
this kind of investigation, they have no incentive to make the results public. Therefore, the cost of
acquiring information and the dilution of ownership create an undersupply of accurate analysis of
large public companies.
Risk biases
A similar problem exists in the risk appetite of individual shareholders and the distorted risk
incentives of institutional investors. Again the phenomena are distinct but related.
Individuals can be shown experimentally to behave irrationally with respect to risk. They consistently
misprice risk by underestimating small probabilities. Individuals also tend to privilege the short term
over the long, in a way that is inconsistent with their stated (and believed) preferences with regard
to immediate consumption.
It can therefore be shown that the risk-taking behaviour of a large body of shareholders may not
allocate capital in the most efficient way.
Risk-taking incentives for larger shareholders are distorted in a different way but with similar results.
Reward structures for some institutional investors are asymmetric – they pay out on short-term
profits but do not confiscate on loss; and those who charge a flat fee unrelated to performance are
still incentivised to achieve high performance in the short term in order to attract more investment
in the medium term. This phenomenon has been widely discussed with regard to the risk-taking
behaviour of bank employees, but exists just the same among investors. This gives them an incentive
to go along with high-risk behaviour within banks.
For these reasons – bounded rationality and risk mispricing – the financial sector is encouraged to
concentrate more heavily on short-term investment than is economically optimal. As a result, there
has historically been lower long-term investment than is optimal.
While these phenomena prima facie apply to any industry sector, there are two reasons why the
finance sector is different.
The first is that other industries have financial professionals as a discipline on their activities. It is
easier for a lender looking inwards to spot high risks – and withdraw the finance they offer – than for
an insider to raise concerns within the finance industry and put their career at risk. To an extent this
reduces risk-taking behaviour and short-term focus within other fields.
The second and more important is that excessive risk-taking and excessive focus on short-term
returns in finance impose a negative externality on the rest of society. Part of the role of the finance
sector in a well-functioning economy is to manage risks and transfer consumption, savings and
investment between people and intertemporally. If its own operations do not rationally allocate risk
this will have a powerful distorting effect on the rest of industry and on consumer behaviour. And if
financial institutions fail, capital is immediately reallocated within the economy without notice, and
into suboptimal places.
Similarly, a healthy finance sector creates positive externalities for the economy, by allowing capital
to be invested where it brings the greatest returns, and allowing consumption to be smoothed by
individuals over a long period.
These externalities argue for public involvement in or regulation of structures which are not
supportive of stable risk allocation and investment. Naturally the nature of such public involvement
needs to be limited, and should be specifically aimed at correcting identified distortions to minimise
politicisation of the regulator’s role.
Information asymmetry and compensation
Information is fundamental to markets. Information asymmetry is correspondingly a common
reason for market failure. And information asymmetry in the market for financial sector
compensation is a major problem.
Compensation is usually and rightly tied to individual and corporate performance. As a principle this
is valuable but it relies on individual and corporate performance being accurately known to both
parties. When performance is measured and announced by one party alone, there is an incentive for
it to be overestimated - either wilfully or simply by selection and survivorship bias.
At the individual level this creates incentives for traders to misrepresent their performance or hide
losses. However, internal governance within banks usually prevents this from becoming a systemic
problem. At the corporate level the problem is harder to solve. Bank management have strong
incentives to declare profits year after year - if necessary with an occasional $40 billion write-down
which eliminates that year's bonuses but prepares the balance sheet for a surging recovery the year
after.
The problem arises because it is bank management who control the published profit figures and
benefit from the figures being presented in a certain way. Auditors have a role in controlling this, but
the conflicts of interest in the audit sector are well-known, and in any case auditors will only ever
have weak incentives to uncover problems. Similarly regulators do their best, but unless they
observe every transaction in every market will not be able to provide a genuine market discipline.
Only lenders or investors have a real interest in identifying the true performance of a company, and
as previously discussed the structure of the markets is such that those incentives are rarely correctly
aligned.
Proposals
To resolve the problems of excessive risk taking and short-termism caused by limited liability
shareholding and bounded rationality, we propose the following:
1. Attention to the ownership structures of banks and financial institutions
2. Incentives for long-term ownership of equity and loan instruments
3. Moves towards meaningful transparency – not just disclosure of data, but knowledge that
can be effectively used by small shareholders and investors
We have not produced detailed policy proposals on these themes but we will outline the arguments
in principle, and give some examples of potential policy actions.
Ownership structures
We propose two policy directions with regard to the ownership of financial institutions.
(1) The creation of more cooperative and savings banks, whose ownership arrangements are less
susceptible to excessive risk-taking, would help to reduce the risk posed by limited liability
ownership and reduce the systemic risk of the sector, by diversifying the business models employed.
The argument for policy encouragement of different ownership structures is that the principalagency
problem combined with limits on farsightedness of economic agents distorts the market’s
normal preference for diversity; and that diversity, because it reduces systemic risk, creates a
positive unpriced externality. This externality means that diversity is undersupplied by the market
acting alone.
(2) The active employment of UK Financial Investments (in the banks which it owns a stake) to
balance the possibility of excessive risk-taking of other shareholders in the future. Moreover, such
activism could be used to address the issue of investor short-termism by tasking UKFI with
championing longer term investments (possibly in areas of strategic importance to the government
such as green technology). This could reasonably be achieved on a commercial basis, without the
government directly interfering with the investment decisions to be made. If the government then
chooses to reduce its shareholdings in the banks over time, this role could be replaced by an
independent statutory body which could appoint board members from people with experience of
industries outside the financial sector. This would serve both to break the cycle of excessive risk
taking and help the UK develop specialisms in sectors that depend on stable long-term finance,
where the UK economy has been historically weak.
In general the goal is not to have public ownership of the banking system but to have stable,
committed owners who can help balance the interests of finance and the rest of the economy.
Encouraging long-term shareholdings is one way to achieve this, as outlined in the next section.
Incentives for long-term ownership
In classical capital markets theory, there should be no difference between short-term and long-term
ownership because the market fully discounts all expected long-term returns into current prices.
In reality, just as in the housing market, long-term ownership of financial assets creates incentives
for investors to invest time in becoming well-informed about their holdings – an investment with
positive externalities for the market as a whole.
In particular, long-term ownership substantially weakens the rational ignorance effect both by
allowing time for investors to become well-informed, and by increasing the returns to such
knowledge.
Thus, there is a strong case for incentivising long-term holding of both equities and bonds. This could
be achieved with a taper-style capital gains tax or corporation tax benefit, or by adjustments to the
stamp duty regime which would discourage short-term holdings. To minimise the distortive effects
of such incentives, it may be plausible to direct them towards particular sizes of shareholding – on
the theory that very small shareholders would be unlikely to carry out meaningful research anyway,
and very large ones should already have sufficient incentive to do so.
Meaningful transparency
The obvious solution for many kinds of information asymmetry is greater transparency. By creating
standards for disclosure, regulators can help restore a balance between market participants who
have been disadvantaged by limited knowledge and those with privileged access to information.
Openness – for example making public the terms of financial contracts that have been entered into
by banks – also allows third parties to make more accurate judgment of counterparty risk and lets
arbitrage impose additional market discipline.
However, two objections must be addressed.
The first is the competitive disadvantage suffered by regulated institutions in comparison to those
elsewhere in the world. If UK banks, for example, are obliged to disclose more information about
their contracts and positions than those elsewhere, the execution of some contracts will move
offshore. One answer to this may be internationally coordinated regulation; another is mechanism
design which gives either or both parties an incentive to disclose the terms of contracts. These issues
do surface, of course, in the negotiations over international accounting standards and there are
ways, albeit imperfect, to deal with it2.
The second objection is that naive disclosure of information is not enough. Straightforward
disclosure requirements in consumer finance do not always achieve the consumer benefit that they
are intended to; consumers often have neither the time nor the understanding to correctly interpret
large amounts of small print. Sophisticated investors are better placed to understand the contracts
they are entering into, but still may not be good at evaluating large amounts of data about banks’
other activities, even if such data were available. Indeed, this is one of the drivers behind innovation
in finance and other markets – once a product has existed long enough to be well-understood by the
majority of buyers, it starts to become commoditised and its suppliers suffer margin pressure. New
products earn higher margins because buyers find it harder to compare them with alternatives.
Workable mechanisms for transparency
In the consumer space, a solution has been proposed by (among others) Sunstein and Thaler3: a
central online portal containing information about credit card terms, allowing consumers to enter
details about their situation and advising on the best option for their individual circumstances. This is
a simple intervention which acts to improve the operation of competition in the interest of
consumers.
Our proposal incorporates elements of this and other transparency mechanisms, with the goal of
using the competitive pressures of the marketplace to complement regulatory actions.
The first step is to develop standardised contracts for the majority of financial products – notably
those such as credit derivatives which are currently traded OTC. These contracts would be published
by regulators, and the users of products would have an incentive to prefer the standard contracts
2 An informative discussion of accounting standards can be found at
http://www.voxeu.org/index.php?q=node/3610
3 Nudge: Improving decisions about health, wealth and happiness, Richard H. Thaler and Cass R. Sunstein, Yale
University Press, 2008
because they have familiar terms. Suppliers would come under market pressure to adopt these
contracts even if they were not made mandatory.
Financial institutions would be required to publish aggregate figures showing the total size and
parameters of these standard contracts they have entered into. This would give the market the
ability to evaluate the overall risk profile of each institution. Currently the rating agencies play a role
in the credit markets which is analogous to this but, to say the least, there is disagreement about the
accuracy of their models. Publishing standard contract terms would allow market participants to
develop and apply their own models to estimate risk.
Institutions would be free to enter into contracts on bespoke terms – although market pressure
would likely put limits on this – but would be required to publish an accurate representation of the
total scale and nature of such contracts. In particular, assets and liabilities which can currently be
held off-balance-sheet would need to be brought onto balance sheet, acknowledged and fairly
valued.
The “market for lemons” argument4 indicates that enforced disclosure is in the interest of both
buyers and sellers: without it, the market is stuck in an unproductive equilibrium where no seller can
credibly disclose information voluntarily, due to free-rider problems. Thus, while no bank would
voluntarily publish its contracts in the current equilibrium, there should not be undue political
resistance to this proposal.
A detailed analysis of disclosure, regulation in general and their interactions with cognitive biases
has been carried out by David Hirschleifer and Siew Hong Teoh5.
Other incentives for research
The transparency argument interacts with the goal of long-term shareholding. As an alternative to
relying on the research efforts of institutional shareholders (which may still be undersupplied if they
do not share information), it would be possible to directly incentivise detailed research which is
made available to the public. Of course, there is already an industry of equity analysts providing such
research – if not to consumers, at least to investment bank clients – but they have had little
credibility since the discovery of systematic biases in their advice, and allegations in a few cases of
direct stock price manipulation, in the early 2000s. The ability to carry out research relies in itself on
greater transparency, as it is questionable whether analysts can give meaningful advice without
more access to detailed company data than they have at present.
It can be argued that the existence of hedge funds and private equity are the best incentives for
research – because if correct, they are able to capture a large share of the benefits while correcting
market prices. However, by its nature this research can only be funded by the losses of investors on
the other side of the hedge funds’ trades. This mechanism encourages prices to get out of line and
become subject to sharp corrections rather than promoting stable and accurate valuations over the
long term.
4 The market for lemons: quality uncertainty and the market mechanism, George A. Akerlof, Quarterly Journal
of Economics, 1970
5 Hirschleifer and Teoh (unpublished), http://mpra.ub.uni-muenchen.de/14046/1/MPRA_paper_14046.pdf
Conclusions
There are inherent cognitive and structural problems in both the ownership and management of
financial services firms which mitigate against efficient market outcomes.
An analysis of these problems shows why they lead to market failure and suggests policy actions
which could move towards correcting them.
Current government ownership of banks through UK Financial Investments offers an opportunity to
act carefully to achieve a public good, without creating a precedent for heavy-handed future
intervention.
Similarly, regulation can be adjusted without restricting the freedom of market participants to
design new products and freely enter into contracts. By increasing transparency and helping small
shareholders and lenders improve their understanding of the risks taken by their agents, and of the
balance between the short and long term, barriers to efficient market operation will be removed."
"A submission to the Walker Review
Sam Robbins and Leigh Caldwell, Intellectual Business
30th May 2009
Intellectual Business is a think tank promoting innovative solutions to business and financial
problems. Its research combines economics, psychology, theory of business and law, and an
understanding of public policy, to build models of how people work and trade together – an
economics based on realistic psychological models and their macro consequences.
Sam Robbins is a former Executive Director of the Equities Division of UBS Investment Bank, London.
He has over ten years experience of financial markets, having worked first as a quantitative analyst
and later as a senior derivatives trader. He has a BA in Mathematics from the University of
Cambridge and an MSc in Government, Policy and Politics, from Birkbeck, University of London.
Leigh Caldwell is founder and director of Intellectual Business. He is also chief executive of Inon, a
technology and economics consultancy founded in 1995 and focused on applying behavioural
economics using Web technology. He has written for VoxEU on behavioural economics and financial
regulation, and has a BSc (Hons) in Mathematics and Physics from the University of Glasgow.
Intellectual Business
23 Jacob Street
London
SE1 2BG
020 7064 6556
http://www.intellectualbusiness.org/
Introduction
In examining corporate governance of financial companies, it is reasonable to ask: why do the
normal incentives of ownership not encourage appropriate behaviour? Shareholders of banks should
be able to discipline excessive risk-taking and encourage high long-term returns, and competitive
market discipline should ensure the optimal social return to financial activities.
In this submission we will argue that there are two main reasons why this does not occur.
The first is that the externalities of the financial sector are not priced correctly. Specifically, limited
liability for shareholders means that they do not bear the full cost of the risks they take; and the
short-term incentives for financial institutions do not reward the long-term return to investment,
which discourages it from taking place. Furthermore, we argue that bank boards did not deviate
from the wishes of their shareholders (prior to the recent crisis) but reflected exactly their revealed
preferences for excessive risk.
The second is that shareholders and other financial market participants are subject to bounded
rationality. There are limits on the information they can process, so they do not make fully informed
decisions and can be taken advantage of by better-informed insiders; and they are subject to
systematic cognitive biases which can distort behaviour and diminish long-term returns.
We explore those problems in further detail below, and then present potential solutions.
Externalities: Limited liability
In this section we argue that the ownership of UK banks by large numbers of small shareholders
contributed to the culture of excessive short-term risk-taking that existed prior to 2007. A
shareholder’s limited liability creates an incentive for them to demand excessive amounts of
leverage, which would not be demanded if they were exposed to the downside this engenders.
Whereas in other industries this pressure towards excessive risk taking is counterbalanced by the
existence of creditors’ desire to protect their investments, we argue that large banks encountered
less resistance from their creditors, because of depositor guarantees and a sector-wide interest in
preserving the status quo. This led to the running down of capital ratios and the increased exposure
of the sector to systemic risk. We will also argue that, though the structure of bankers’ remuneration
did lead to excessive long-term risk-taking for short-term gain, this culture evolved to satisfy the
preferences of shareholders, and any solution to the problem of excessive risk-taking must therefore
encompass how banks are owned as well as how they are managed.
The larger UK retail banks are typically owned by large numbers of small shareholders. Our
experience in the financial sector suggests that investors’ collective behaviour, prior to 2007, was to
actively target the banks offering maximum returns on investment, without any particular attention
to the risks involved. Investors would routinely target returns on equity as high as 20% and punish
stocks which did not achieve such exaggerated rates of return. We argue that banks and other
financial institutions increased their leverage as a response to this demand. Shareholders rationally
demanded this extra risk be taken, because their limited liability meant that, whilst their downside
was strictly capped at the level of their investment, their upside exposure could effectively be
multiplied through the process of leveraging.
Although the limited liability of shareholders creates the potential demand for excessive risk-taking
in any company, we argue that in most cases this is not realised because of the countervailing power
of their creditors. Banks are an exception to this rule, as they have considerable power to determine
how leveraged they are. Firstly, small depositors, who provide a significant fraction of all the
liabilities on a bank’s balance sheet, are widely covered by the Financial Services Compensation
Scheme, and so have a reduced incentive to scrutinise the bank’s financial health. Secondly, banks
often lend to other banks, who share an incentive to maximise their lending. Finally, regulators have
been historically weak in maintaining rules on capital ratios, in the face of an industry equipped with
large amounts of expertise in risk management. These factors combined to permit a situation in
which bankers, acting on behalf of their shareholders, took (and were able to take) excessive risks.
Bankers’ remuneration packages evolved to fulfil the needs of shareholders. Whilst much recent
commentary has revolved around the incorrectness of the incentive structures this created, we
argue that this was epiphenomenal, and ultimately caused by shareholder preferences. Shareholders
of banks consistently voted for the remuneration packages that were put in front of them. Longer
term remuneration packages (with “clawback” provisions for poor performance in later years) were
not previously implemented, as shareholders were not prepared to accept the possible loss of
personnel (and damage to shorter term returns) that would have resulted. Put another way, they
shared both the investment horizon and the moral hazard of the bankers they employed – counter
to the common perception that a principal-agency problem caused risk-taking distortions. We argue
that a change in the ownership structure of a bank, and a consequent change of risk preference,
would contribute to resolving the issue of banker remuneration, at the same time as resolving the
problem of excessive risk-taking.
Externalities: Is the finance sector acting in the interests of industry?
For public welfare to be maximised, individuals and firms together need to be able to choose the mix
of consumption, savings, borrowing and investment that is right for them over the long term.
The finance sector is the essential intermediary in this choice and in particular, it has a role in
delivering the appropriate amount of capital for investment in future productivity.
There is room for debate about the correct level and form of that investment, but at present it
appears that productive investment in the UK economy is running at levels below what is desired by
citizens. That the investment level may be less than its long-term average is not in itself a problem -
the choice made by consumers between current and deferred consumption may simply be different
to the choice made in previous decades. But if the level of investment that consumers wish to make
is not being achieved because of perverse incentives or behaviour within the finance sector, that is a
problem with major long-term costs.
Are the financial markets, then, underproviding capital for productive investment? We argue that
they are. The bias towards short-term returns and the nature of governance and reward structures
in the finance sector make it harder for banks and institutions to extend long-term lending to
corporates. In the short term this permits increased consumption but in the long term it will result in
slower growth and reduced living standards. Business investment figures1 suggest that UK
investment has historically been, and remains, lower than that in most other countries.
1 See for example http://www.bankofengland.co.uk/publications/speeches/2006/speech282.pdf, a speech by
Sir John Gieve, for discussion and sources
Bounded rationality: Cognitive bounds of small (and large) shareholders
A model where a complex company is owned by a large and diverse group of shareholders will
always suffer from problems of both information asymmetry and bounded cognition.
Rational ignorance
Bounded cognition of small shareholders (especially individuals, but also fund managers) creates
problems of misaligned incentives or “rational ignorance”. While better known as a problem in
public choice economics, rational ignorance is of critical importance in corporate governance too.
The problem can be summarised as follows: the cost to a small shareholder of carrying out proper
due diligence on a company, or even spending time to understand what it does, far outweighs any
possible benefit. An individual who holds £2,000 of RBS shares might need to spend weeks educating
herself to understand even a small part of the risks the company is taking, the likely future path of
the credit markets it is involved in, and so on. But the cost of that investigation will be several
thousand pounds in the investor’s time alone. The maximum possible benefit she can achieve is to
save their £2,000 investment by selling the shares before the company collapses, and so a simple
cost-benefit analysis says that she should not bother investing the time to learn about the
investment she is making.
The problem for larger investors is similar though at a different level. A fund manager holding £100
million of RBS shares can be expected to have carried out a certain level of research into the
financial sector and the risks their shares are exposed to. But to carry out proper due diligence on
their investment – of the kind that any venture capitalist would carry out on a startup they are
investing in – would be so expensive for a company of RBS’s size that it would outweigh any likely
benefit. A likely cost running into millions of pounds could in theory be recouped if the share price
were to move by a couple of percent, but the incentives within the fund management structure are
likely to make this cost prohibitive. The fund manager is unlikely to have the freedom to spend his
investors’ money on such investigations, and thus they would have to cover it from their own fees –
which will never be high enough to make it worthwhile, even if the value of the investment were to
move by as much as 50%.
While large private equity investors and hedge funds might have sufficient incentives to carry out
this kind of investigation, they have no incentive to make the results public. Therefore, the cost of
acquiring information and the dilution of ownership create an undersupply of accurate analysis of
large public companies.
Risk biases
A similar problem exists in the risk appetite of individual shareholders and the distorted risk
incentives of institutional investors. Again the phenomena are distinct but related.
Individuals can be shown experimentally to behave irrationally with respect to risk. They consistently
misprice risk by underestimating small probabilities. Individuals also tend to privilege the short term
over the long, in a way that is inconsistent with their stated (and believed) preferences with regard
to immediate consumption.
It can therefore be shown that the risk-taking behaviour of a large body of shareholders may not
allocate capital in the most efficient way.
Risk-taking incentives for larger shareholders are distorted in a different way but with similar results.
Reward structures for some institutional investors are asymmetric – they pay out on short-term
profits but do not confiscate on loss; and those who charge a flat fee unrelated to performance are
still incentivised to achieve high performance in the short term in order to attract more investment
in the medium term. This phenomenon has been widely discussed with regard to the risk-taking
behaviour of bank employees, but exists just the same among investors. This gives them an incentive
to go along with high-risk behaviour within banks.
For these reasons – bounded rationality and risk mispricing – the financial sector is encouraged to
concentrate more heavily on short-term investment than is economically optimal. As a result, there
has historically been lower long-term investment than is optimal.
While these phenomena prima facie apply to any industry sector, there are two reasons why the
finance sector is different.
The first is that other industries have financial professionals as a discipline on their activities. It is
easier for a lender looking inwards to spot high risks – and withdraw the finance they offer – than for
an insider to raise concerns within the finance industry and put their career at risk. To an extent this
reduces risk-taking behaviour and short-term focus within other fields.
The second and more important is that excessive risk-taking and excessive focus on short-term
returns in finance impose a negative externality on the rest of society. Part of the role of the finance
sector in a well-functioning economy is to manage risks and transfer consumption, savings and
investment between people and intertemporally. If its own operations do not rationally allocate risk
this will have a powerful distorting effect on the rest of industry and on consumer behaviour. And if
financial institutions fail, capital is immediately reallocated within the economy without notice, and
into suboptimal places.
Similarly, a healthy finance sector creates positive externalities for the economy, by allowing capital
to be invested where it brings the greatest returns, and allowing consumption to be smoothed by
individuals over a long period.
These externalities argue for public involvement in or regulation of structures which are not
supportive of stable risk allocation and investment. Naturally the nature of such public involvement
needs to be limited, and should be specifically aimed at correcting identified distortions to minimise
politicisation of the regulator’s role.
Information asymmetry and compensation
Information is fundamental to markets. Information asymmetry is correspondingly a common
reason for market failure. And information asymmetry in the market for financial sector
compensation is a major problem.
Compensation is usually and rightly tied to individual and corporate performance. As a principle this
is valuable but it relies on individual and corporate performance being accurately known to both
parties. When performance is measured and announced by one party alone, there is an incentive for
it to be overestimated - either wilfully or simply by selection and survivorship bias.
At the individual level this creates incentives for traders to misrepresent their performance or hide
losses. However, internal governance within banks usually prevents this from becoming a systemic
problem. At the corporate level the problem is harder to solve. Bank management have strong
incentives to declare profits year after year - if necessary with an occasional $40 billion write-down
which eliminates that year's bonuses but prepares the balance sheet for a surging recovery the year
after.
The problem arises because it is bank management who control the published profit figures and
benefit from the figures being presented in a certain way. Auditors have a role in controlling this, but
the conflicts of interest in the audit sector are well-known, and in any case auditors will only ever
have weak incentives to uncover problems. Similarly regulators do their best, but unless they
observe every transaction in every market will not be able to provide a genuine market discipline.
Only lenders or investors have a real interest in identifying the true performance of a company, and
as previously discussed the structure of the markets is such that those incentives are rarely correctly
aligned.
Proposals
To resolve the problems of excessive risk taking and short-termism caused by limited liability
shareholding and bounded rationality, we propose the following:
1. Attention to the ownership structures of banks and financial institutions
2. Incentives for long-term ownership of equity and loan instruments
3. Moves towards meaningful transparency – not just disclosure of data, but knowledge that
can be effectively used by small shareholders and investors
We have not produced detailed policy proposals on these themes but we will outline the arguments
in principle, and give some examples of potential policy actions.
Ownership structures
We propose two policy directions with regard to the ownership of financial institutions.
(1) The creation of more cooperative and savings banks, whose ownership arrangements are less
susceptible to excessive risk-taking, would help to reduce the risk posed by limited liability
ownership and reduce the systemic risk of the sector, by diversifying the business models employed.
The argument for policy encouragement of different ownership structures is that the principalagency
problem combined with limits on farsightedness of economic agents distorts the market’s
normal preference for diversity; and that diversity, because it reduces systemic risk, creates a
positive unpriced externality. This externality means that diversity is undersupplied by the market
acting alone.
(2) The active employment of UK Financial Investments (in the banks which it owns a stake) to
balance the possibility of excessive risk-taking of other shareholders in the future. Moreover, such
activism could be used to address the issue of investor short-termism by tasking UKFI with
championing longer term investments (possibly in areas of strategic importance to the government
such as green technology). This could reasonably be achieved on a commercial basis, without the
government directly interfering with the investment decisions to be made. If the government then
chooses to reduce its shareholdings in the banks over time, this role could be replaced by an
independent statutory body which could appoint board members from people with experience of
industries outside the financial sector. This would serve both to break the cycle of excessive risk
taking and help the UK develop specialisms in sectors that depend on stable long-term finance,
where the UK economy has been historically weak.
In general the goal is not to have public ownership of the banking system but to have stable,
committed owners who can help balance the interests of finance and the rest of the economy.
Encouraging long-term shareholdings is one way to achieve this, as outlined in the next section.
Incentives for long-term ownership
In classical capital markets theory, there should be no difference between short-term and long-term
ownership because the market fully discounts all expected long-term returns into current prices.
In reality, just as in the housing market, long-term ownership of financial assets creates incentives
for investors to invest time in becoming well-informed about their holdings – an investment with
positive externalities for the market as a whole.
In particular, long-term ownership substantially weakens the rational ignorance effect both by
allowing time for investors to become well-informed, and by increasing the returns to such
knowledge.
Thus, there is a strong case for incentivising long-term holding of both equities and bonds. This could
be achieved with a taper-style capital gains tax or corporation tax benefit, or by adjustments to the
stamp duty regime which would discourage short-term holdings. To minimise the distortive effects
of such incentives, it may be plausible to direct them towards particular sizes of shareholding – on
the theory that very small shareholders would be unlikely to carry out meaningful research anyway,
and very large ones should already have sufficient incentive to do so.
Meaningful transparency
The obvious solution for many kinds of information asymmetry is greater transparency. By creating
standards for disclosure, regulators can help restore a balance between market participants who
have been disadvantaged by limited knowledge and those with privileged access to information.
Openness – for example making public the terms of financial contracts that have been entered into
by banks – also allows third parties to make more accurate judgment of counterparty risk and lets
arbitrage impose additional market discipline.
However, two objections must be addressed.
The first is the competitive disadvantage suffered by regulated institutions in comparison to those
elsewhere in the world. If UK banks, for example, are obliged to disclose more information about
their contracts and positions than those elsewhere, the execution of some contracts will move
offshore. One answer to this may be internationally coordinated regulation; another is mechanism
design which gives either or both parties an incentive to disclose the terms of contracts. These issues
do surface, of course, in the negotiations over international accounting standards and there are
ways, albeit imperfect, to deal with it2.
The second objection is that naive disclosure of information is not enough. Straightforward
disclosure requirements in consumer finance do not always achieve the consumer benefit that they
are intended to; consumers often have neither the time nor the understanding to correctly interpret
large amounts of small print. Sophisticated investors are better placed to understand the contracts
they are entering into, but still may not be good at evaluating large amounts of data about banks’
other activities, even if such data were available. Indeed, this is one of the drivers behind innovation
in finance and other markets – once a product has existed long enough to be well-understood by the
majority of buyers, it starts to become commoditised and its suppliers suffer margin pressure. New
products earn higher margins because buyers find it harder to compare them with alternatives.
Workable mechanisms for transparency
In the consumer space, a solution has been proposed by (among others) Sunstein and Thaler3: a
central online portal containing information about credit card terms, allowing consumers to enter
details about their situation and advising on the best option for their individual circumstances. This is
a simple intervention which acts to improve the operation of competition in the interest of
consumers.
Our proposal incorporates elements of this and other transparency mechanisms, with the goal of
using the competitive pressures of the marketplace to complement regulatory actions.
The first step is to develop standardised contracts for the majority of financial products – notably
those such as credit derivatives which are currently traded OTC. These contracts would be published
by regulators, and the users of products would have an incentive to prefer the standard contracts
2 An informative discussion of accounting standards can be found at
http://www.voxeu.org/index.php?q=node/3610
3 Nudge: Improving decisions about health, wealth and happiness, Richard H. Thaler and Cass R. Sunstein, Yale
University Press, 2008
because they have familiar terms. Suppliers would come under market pressure to adopt these
contracts even if they were not made mandatory.
Financial institutions would be required to publish aggregate figures showing the total size and
parameters of these standard contracts they have entered into. This would give the market the
ability to evaluate the overall risk profile of each institution. Currently the rating agencies play a role
in the credit markets which is analogous to this but, to say the least, there is disagreement about the
accuracy of their models. Publishing standard contract terms would allow market participants to
develop and apply their own models to estimate risk.
Institutions would be free to enter into contracts on bespoke terms – although market pressure
would likely put limits on this – but would be required to publish an accurate representation of the
total scale and nature of such contracts. In particular, assets and liabilities which can currently be
held off-balance-sheet would need to be brought onto balance sheet, acknowledged and fairly
valued.
The “market for lemons” argument4 indicates that enforced disclosure is in the interest of both
buyers and sellers: without it, the market is stuck in an unproductive equilibrium where no seller can
credibly disclose information voluntarily, due to free-rider problems. Thus, while no bank would
voluntarily publish its contracts in the current equilibrium, there should not be undue political
resistance to this proposal.
A detailed analysis of disclosure, regulation in general and their interactions with cognitive biases
has been carried out by David Hirschleifer and Siew Hong Teoh5.
Other incentives for research
The transparency argument interacts with the goal of long-term shareholding. As an alternative to
relying on the research efforts of institutional shareholders (which may still be undersupplied if they
do not share information), it would be possible to directly incentivise detailed research which is
made available to the public. Of course, there is already an industry of equity analysts providing such
research – if not to consumers, at least to investment bank clients – but they have had little
credibility since the discovery of systematic biases in their advice, and allegations in a few cases of
direct stock price manipulation, in the early 2000s. The ability to carry out research relies in itself on
greater transparency, as it is questionable whether analysts can give meaningful advice without
more access to detailed company data than they have at present.
It can be argued that the existence of hedge funds and private equity are the best incentives for
research – because if correct, they are able to capture a large share of the benefits while correcting
market prices. However, by its nature this research can only be funded by the losses of investors on
the other side of the hedge funds’ trades. This mechanism encourages prices to get out of line and
become subject to sharp corrections rather than promoting stable and accurate valuations over the
long term.
4 The market for lemons: quality uncertainty and the market mechanism, George A. Akerlof, Quarterly Journal
of Economics, 1970
5 Hirschleifer and Teoh (unpublished), http://mpra.ub.uni-muenchen.de/14046/1/MPRA_paper_14046.pdf
Conclusions
There are inherent cognitive and structural problems in both the ownership and management of
financial services firms which mitigate against efficient market outcomes.
An analysis of these problems shows why they lead to market failure and suggests policy actions
which could move towards correcting them.
Current government ownership of banks through UK Financial Investments offers an opportunity to
act carefully to achieve a public good, without creating a precedent for heavy-handed future
intervention.
Similarly, regulation can be adjusted without restricting the freedom of market participants to
design new products and freely enter into contracts. By increasing transparency and helping small
shareholders and lenders improve their understanding of the risks taken by their agents, and of the
balance between the short and long term, barriers to efficient market operation will be removed."
Me:
Don said...
"Bankers’ remuneration packages evolved to fulfil the needs of shareholders. Whilst much recent
commentary has revolved around the incorrectness of the incentive structures this created, we
argue that this was epiphenomenal, and ultimately caused by shareholder preferences. Shareholders
of banks consistently voted for the remuneration packages that were put in front of them. Longer
term remuneration packages (with “clawback” provisions for poor performance in later years) were
not previously implemented, as shareholders were not prepared to accept the possible loss of
personnel (and damage to shorter term returns) that would have resulted. Put another way, they
shared both the investment horizon and the moral hazard of the bankers they employed – counter
to the common perception that a principal-agency problem caused risk-taking distortions. We argue
that a change in the ownership structure of a bank, and a consequent change of risk preference,
would contribute to resolving the issue of banker remuneration, at the same time as resolving the
problem of excessive risk-taking."
I agree, and am saying the following about Ponzi Schemes here:
"I still believe that the best lobbyists for a Ponzi Scheme are the clients, many, if not all, of whom, are wealthy and well connected, with easy access to lawyers. After all, you have to go to these clients and say:
“We’d like to look into your investment, since you’re getting unnaturally high returns.”
The answer might well be:
“You don’t say. Fancy that. That’s what I’m paying this person for!”
Perhaps someone could look into what, if anything, clients said or did, during these years. "
But, look, the answer to this question could have already been answered by considering Ponzi Schemes. After all, if I'm an investor in a Ponzi Scheme, and I figure that out whilst no one else invested in it has, the savvy thing to do is for me to stay in the PS, reaping high returns, but be gradually, w/o causing much fuss, withdrawing my money. In fact, one can imagine hedge funds and mutual funds dedicated to identifying PSs, and then investing in them in such a way as I just postulated for a savvy investor. A kind of market timing. Of course, their portfolio would need to be secret.
In order to disallow this, a court can take back money from investors in a PS who exit early, and put management in jail. Conceptually, these are both "Clawbacks". Hence, clawbacks are a necessary part of any solution. As with monitoring for PSs, it can only be of limited use given the nature of the endeavor, which is to make money. In making money, human beings lose a large amount of common sense and skepticism.Period. What you make transparent, they will view differently. Quite frankly, this is why reading crime novels is such an excellent place to discover human behavior in the real world. To understand x, look at how people scam it.
Now, on Epiphenomenalism. As I understand it, this concept arose as a solution to the Mind-Body Problem. The solution being that the body is causal, whilst the mind is not. However, I believe the point is that the Mind cannot, ever, be causal. In other words, it's not simply a case of an incorrectly ascribed cause. Yet, that now seems to be the meaning. Whilst X seems to be the cause, it's really Y. But that's not the same thing as arguing that X can't be the cause. It's not in its nature to be a cause.
Also, you have to believe that there is a Mind-Body Problem that needs solving. If you don't, it's not a very useful concept.
Don the libertarian Democrat
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