Typical street scene in Santa Ana, El Salvador. (Photo: iStock)
IMF Survey : Bank Compensation, Governance Need Upgrade to Make Financial System Safer
October 1, 2014
- Bank managers, shareholders often take too much risk, disregard cost to society
- Bank creditors lack incentives to monitor risk
- Banks need independent boards of directors
Banks with more independent boards of directors that pay executives according to long-term performance tend to incur fewer risks, according to new research from the International Monetary Fund.
New York’s Wall Street: excessive risk taking by banks fueled the global financial crisis (photo: Samuel Aranda/Corbis)
GLOBAL FINANCIAL STABILITY REPORT
The IMF’s latest Global Financial Stability Report analyzes the excessive risk taking by banks that contributed to the global financial crisis, and proposes reforms to help prevent future abuses given the huge costs to society, both economic and social.
The IMF analysis provides new research into the role of governance and executive pay. This research is necessary to help shape the reforms to strengthen regulations, realign incentives, and foster stronger risk management and oversight in banks.
“Financial regulatory reform has gone a long way toward improving standards for governance and executive pay,” noted Gaston Gelos, Chief of the Global Financial Stability Division at the IMF. “But in some areas we need to go further—for example, by making executive compensation more sensitive to default risk and more dependent on longer-term outcomes. Bankers should be rewarded for creating long-term value, not for short-term bets.”
Although taking a healthy dose of risk is part of a bank’s mission, they sometimes take on more risks than is socially desirable.
Risky business
The report studies the association between risk taking, governance, and executive pay based on a large sample of banks around the world.
According to the IMF, banks with board members who are independent of bank management tend to incur less risk. Also, banks where executive compensation depends to a larger extent on long-term performance show lower levels of risk taking.
However, the level of executive compensation is not consistently associated with risk taking. Banks that have a stronger risk management function and large institutional ownership tend to take less risk, the IMF said. Banks where the CEO has a professional background in retail banking or risk management—a proxy for a more conservative risk culture—also show lower levels or risk.
Some compensation practices—such as measuring performance with gross revenue—may bias managers’ decision making toward activities with short-term gains and hidden long-term costs, or managers may choose risky investments that may compromise the bank’s solvency. This behavior may even be in interest of shareholders who prefer risky bets because their losses are limited and the potential gains are substantial.
The IMF said banks with a large amount of debt have heightened risks. The same is true when a bank is close to defaulting. In both circumstances, managers and shareholders have little to lose and are tempted to “gamble for resurrection” as they would receive the profits from the gamble but the losses would be borne mostly by creditors.
Debt holders, including depositors, are not sufficiently vigilant against such behavior because they feel protected by deposit insurance and implicit government guarantees. Even without these protections, creditors may be unable to fully monitor the risk of large financial institutions which are complex, opaque, and have systemic importance.
To improve such monitoring, “policymakers should study ways of having creditors, not just shareholders, represented in bank boards,” Gelos said.
Policies to limit risk
The report empirically supports some of the policy measures currently being debated or implemented, and recommends new ones:
• First, banks should better align compensation with risk. Banks could link compensation better to their creditworthiness by, for example, paying managers partly with long-term bank bonds.
• Second, variable compensation should be deferred in time and include clawback provisions, which are contractual clauses that may force managers to return past bonuses in certain cases, for example if their decisions cause losses over the longer term.
• Third, banks’ boards of directors need to be independent of bank management and should establish risk committees. In addition, policymakers should consider measures to ensure that boards take into account not only the interests of shareholders but also those of debt holders.
• Fourth, financial supervisors have a role to ensure that boards conduct effective oversight of risk taking in banks and that a bank’s risk culture is consistent with financial stability.
• Finally, banks need to be transparent to foster accountability and strengthen market discipline.
The IMF will release more analysis from the Global Financial Stability Report on October 8.