The IMF released its October Global Financial Stability Report, as usual opening up the two weeks long run with the analytical chapters. The first instalment of new analysis from the Fund focused on the role of governance and executive pay in determining the risk taking behaviour of the banks.
The topic is a financial and political hot potato. There is a very strong consensus in the media, policy making circles, amongst analysts and the general public that in the years of the so-called Great Moderation (the period of subdued inflation, generally accommodative interest rates and robust growth that started the mid-1990s and lasted through 1H 2007) reckless risk behaviour by the banks has led to the emergence of the financial weaknesses that subsequently erupted in the global financial crisis.
Generally, risk taking behaviour of the banks is determined by a number of factors, including:
- Internal incentives for banks managers to take excessive risks without providing sufficient risk control and hedging cover;
- External incentives for the banks to take heavier risk exposures that come in the form of excessive liquidity in funding markets, low cost of funding, opportunities for carry trades (ability of the banks to engage in interest rate arbitrage across the borders), and emergence of asset bubbles that create a sense of invincibility for investors;
- Internal facilitators for the banks to take on risk, including lax and/or easing constraints from the corporate governance and internal controls, and increased shareholders’ pressure to raise dividends and equity valuations; and
- External facilitators, such as lax supervision and enforcement of regulations, as well as political pressure on the banks to lend into specific sectors of economy, such as property.
Since the eruption of the crisis, various national and international authorities have attempted implementation of different sets of reforms aimed at addressing some of the above drivers. Some of these reforms were targeting ‘hard metrics’, such as capital requirements and liquidity buffers.
Others are focusing on incentives for the bankers to take on excessive risks.
IMF analysis shows that the latter type of reforms can indeed be effective in mitigating the adverse risk taking behaviour of the banks, if these measures are properly designed. Specifically, IMF researchers found that banks with higher number of independent board members tend to take on less risk.
Debunking some populist myths, the IMF also found that “the level of executive compensation in banks is not consistently related to their risk taking. More pay that is related to longer-term job performance is associated with less risk.” In other words, whilst it does matter what executive pay strategy the bank pursues, actual level of pay does not matter in determining levels of risk assumed by the bank. Neither “monkeys for peanuts” nor “riches for brains” strategy for hiring executives shows up as an efficient way of mitigating risks.
Ownership structure of the bank, however, is a significant factor in driving risk behaviour: as IMF found out, banks that have large institutional ownership tend to take less risk. In other words, more activist, highly concentrated in voting power owners with independent capacity to assess bank’s performance and balance sheet risks have greater impact on bank risk taking behaviour.
The chart below shows the importance of all of the above factors in driving down risk-taking behaviour by the banks:
Title: Summary of Main Findings: Impact on Risk Taking (z-statistics)
Note to chart: The figure shows z-statistics—a measure that gives a statistical indication of the significance of the effect of each explanatory variable on risk. Solid and dashed lines indicate 5 and 10 percent levels of significance, respectively.
Source: IMF, GFSR 2014.
The IMF research also throws some light on the trends in executive compensation across time and regions.
Firstly, whilst the banking sector performance is still lagging pre-crisis levels, banks’ executive pay has now recovered to pre-crisis levels. In non-English speaking Europe, salaries gained a major share in total executive pay compensation in 2012-2013 compared to 2006-2007. This occurred primarily due to the decline of relative importance of performance bonuses. In English-speaking countries, however, the share of salaries in total compensation remained static, but there was a marked rise in the share attributable to longer-term incentives-linked pay. The two banking systems are thus moving in the opposite direction in attempting to reduce executives’ incentives to take on risk.
Banking systems in English-speaking countries are the leaders in the degree of board independence with well over 70% of board members accounted for by independent directors. In non-English-speaking Europe that proportion is roughly 45%.
Worldwide, there has been a major shift in favour of granting shareholders rights to vote on executive compensation. In 2005, just over 11% of the larger banks (assets of USD10 billion and over) allowed shareholders a right to vote on the issue. By 2007 this rose to roughly 30% and by 2013 to over 81%.
In short, it turns out that governance systems, voting rights, ownership structures and the type (not the level) of executive compensation all matter when it comes to determining banks’ attitudes toward risk taking.
Dr Constantin Gurdgiev is the Adjunct Assistant Professor of Finance with Trinity College, Dublin
