A developed society like ours needs a good means of exchange, unit of account and store of value: a good money. It also needs a vibrant, dynamic, reliable and robust means of executing payments and intermediating savings to entrepreneurs: we need a good banking system.
Of all the many ways of organising banking, the worst is the one we have today.
And I agree with the Governor of the Bank of England.
He said elsewhere in that speech, “At the heart of this crisis was the expansion and subsequent contraction of the balance sheet of the banking system.” We might well discuss why the money supply is so elastic and why it expanded so far.
The financial system is characterised by territorial monopolies on irredeemable fiat money, central banking, fractional reserve deposit taking, deposit insurance, limited liability and extensive, albeit failed, regulation, such as the use of IFRS accounting. It is this set of institutional factors which enabled the vast credit and business cycle from which the western world is now struggling to recover and which delivered vast private profits with socialised risks.
It isn’t good enough to blame individuals’ behaviour. Greed, irresponsibility and entrepreneurial error are not recent innovations in human nature. The system should have been able to cope.
As I reported yesterday, the Bank of England’s Executive Director for Financial Stability, Andy Haldane, published an article in which he wrote:
The continuing backlash against banking, as evidenced in popular protests on Wall Street and in the City of London, is a response not just to the fact that the world is poorer, as pre-crisis riches have turned to rags, but to the way these riches were privatised, while the rags are being socialised. This disparity is nothing new. Neither, in the main, is it anyone’s fault. For the most part the financial crisis was not the result of individual wickedness or folly. It is not a story of pantomime villains and village idiots. Instead the crisis reflected a failure of the entire system of financial sector governance.
Quite so, but moreover,
The best proposals for reform are those which aim to reshape risk-taking incentives on a durable basis.
In my Ten-Minute Rule motion on Wednesday after Prime Minister’s Questions, I will seek leave to introduce a bill to improve the governance of banks by adjusting directors’ and employees’ exposure to risk: the Financial Institutions (Reform) Bill. I’m grateful to Kevin Dowd, co-author of The Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System, and Gordon Kerr, author of The Law of Opposites, for their help in formulating these proposals.
The purpose of the Bill is to implement a series of mutually-reinforcing measures to resolve the financial crisis and minimise the chance of a future crisis. It is intended to:
- Preserve and extend commercial freedom,
- Promote personal, professional and mutual responsibility,
- Facilitate enterprise under the rule of law, avoiding excessive intervention by regulators,
- Deliver justice, so that those who stand to gain bear the risks of failure.
The fundamental principle is to make bankers liable for their own actions, so reining-in rampant moral hazards and excessive risk-taking. These measures would restore the integrity of the financial system and provide a sound basis on which the UK could continue to lead the world in financial services.
They would also address widespread public indignation and meet the demand for accountability and justice in contemporary banking.
In this and two subsequent articles leading up to my speech in Parliament on Wednesday, I’ll set out my proposals. Today I cover the liability of bankers and the treatment of bonuses.
1. Liability of bankers
1.1 Board members of financial institutions would be strictly liable for any losses reported by their institutions. Strict liability means that they are held to be liable without the need to prove fault on their part.
1.2 Board members of financial institutions would to be subject to unlimited personal liability for any such losses. Their own personal wealth – all assets, houses, pensions, etc. – is to be at risk if their banks beome insolvent.
Both directors and auditors already have open-ended liability in law in certain circumstances but they have to be successfully sued. Enforcing strict liability openly and transparently extends certain principles already in UK law.
1.3 Board members of financial institutions would be required to post personal bonds that would be potentially forfeit in the event that their banks report losses. This measure ensures that board members provide a form of additional core capital of known value that would be easily seizeable to cover bank losses.
1.4 The value of the bonds posted for each person concerned should be the higher of £2m adjusted for future RPI or 50% of the person’s net wealth.
1.5 Any board members who resign would still be subject to unlimited personal liability and the requirement to post bonds for a period of 2 years following their resignation.
This is to prevent directors running away from recently incurred but not reported losses by resigning before the losses are reported: hence this requirement means that if the roof should just happen to fall in any time within 2 years of their leaving, they are still liable, no excuses.
This should take care of the common problem of soon-to-retire execs deferring problems until they themselves had just got out of the door. The 2-year expiration period would also counteract short-termism by giving board members an incentive to ensure that they are replaced by responsible successors.
2. Bonus payments to be deferred and liable
2.1 The payment of any bonuses that are awarded in any given year would be deferred for a period of 5 years.
2.2 The amounts involved — the bonus pool — would be invested on beneficiaries’ behalf in an escrow account. Where the bonus takes the form of stocks, these would typically accumulate dividend payments over time. Where they include stock options, such options would be exercised on maturity if they expired in-the-money and so then convert to underlying stock positions, and if they expired out-of-the-money they would become worthless. Where the bonus takes the form of cash, these cash amounts would be invested in an independent money market mutual fund with a horizon period equal to the period when the original 5-year deferment has lapsed and payments can then be made to beneficiaries.
2.3 The reason for this requirement is that bankers and traders are good at creating personally lucrative time bombs that blow up years later when the individuals responsible have long since departed with their bonuses. Under current rules, past remuneration cannot be retrieved by the bank when the damage is eventually revealed. The deferment period therefore needs to be a fairly long one.
Further notes on these provisions will be released on Wednesday.
2.4 The bonus pool would provide an additional form of core capital that would be used to make good any reported losses.
The beneficiaries of the bonus pool include not just board members, but also, e.g., traders. Thus, the traders’ bonuses are also at risk – and of course, the bigger the traders’ bonuses, the more they have at-risk. This will help to discourage traders from excessive risk-taking, as their own accumulated bonuses would be in line to cover any losses. It is also likely to encourage mutual responsibility and cooperation with risk managers.
Tomorrow, I’ll discuss how losses should be covered and, on Wednesday, I’ll indicate other provisions, releasing more comprehensive details for download.
Tags: Financial Crisis, Financial Institutions (Reform) Bill, Governance, Liability, Moral Hazard, Parliament, Risk