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Saturday September 19, 2009

Wall Street’s mixed-up take on risk, return and rewards

A QUESTION OF BUSINESS
By P. GUNASEGARAM


Encouraging executives to risk all for high returns and rewards is the surest recipe for disaster, not success

… We are proposing the most ambitious overhaul of the financial system since the Great Depression – US President Barack Obama, earlier this week.

TWO things have to change before the US can put its banking houses in order and prevent a recurrence of the financial crisis that saw a collapse of banks in the developed world and threatened a catastrophe of unimagined proportions throughout the world.

First, the way that bank employees are rewarded should be completely revamped so that they are not rewarded for taking undue risks but punished instead. Second, US banks, funds and financial institutions must subject themselves to greater regulation.

There are clear indications that US President Barack Obama understands this – and this was exemplified in a speech he made earlier this week where he stressed that major changes were necessary to forestall any recurrence of a crisis of this magnitude.

“Taken together, we are proposing the most ambitious overhaul of the financial system since the Great Depression. But I want to emphasise that these reforms are rooted in a simple principle: we ought to set clear rules of the road that promote transparency and accountability.

“That’s how we’ll make certain that markets foster responsibility, not recklessness, and reward those who compete honestly and vigorously within the system, instead of those who try to game the system,” he said.

We couldn’t agree more. But he is under pressure at home from the right which opposes anything that messes around with the so-called free market mechanism. There was a large demonstration in Washington numbering in the tens of thousands to put this point across to Obama.

While one can expect the free market rhetoric to get louder to put down badly needed reforms of the US financial sector – and thereby perpetuate the system of high rewards – one hopes that Obama will have the fortitude and the support to go through with it nevertheless. Otherwise, nothing would have changed.

The problem with Wall Street is that it has forgotten financial basics, of which a tenet is that great returns come from great risks. If markets are substantially free and perfect – that is not influenced by any party and reflect all available information – then higher returns can only be obtained from higher risks.

If employees are able to generate excessively high returns, alarm bells should start ringing and banks should be looking at the amount of risk they are taking. Worse, employee rewards are structured to returns – short-term returns – which encourages excessive risk-taking. If the employee hits jackpot, he gets part of it. If he does not, he merely gets his employer into trouble – that’s all.

So employees will do all to get short-term gains at high risk because they benefit from the upside but don’t care much if losses are made because they don’t share in the loss – a new kind of moral hazard that financial institutions must handle.

That’s in addition to the traditional moral hazard that banks face – the readiness of government to save them from collapse encourages them as institutions to take higher risks because you cannot afford to have them fail.

For the reward structure, let’s look at a hedge fund. You pay management fees for the fund to manage your money. In addition, as much as 20% or more of your profit goes to the hedge fund managers as incentive. What would you do if you were a hedge fund manager? Take risks of course. The bigger the return, the bigger the risk you effectively take and the bigger the potential rewards.

An additional problem is the deregulation in the US. The lines between commercial and investment banking have become blurred so much so that banks use depositor’s money to gamble, or to use Obama’s more polite term, game.

These banks and financial institutions must simply realise that if they take money from the public, then they will be watched – closely. If you take money from depositors, you will be closely regulated. Period. And that means hedge funds too.

It’s curious that a huge section of US business does not seem to understand this. Perhaps it does not want to because that reduces the scope for making excessive profits through financial intermediation.

Other countries should do their part to prevail on the US to rein in their large miscreant financial institutions, and pay attention to the basic rules of finance and regulation. The world’s financial health depends on that.

Managing editor P. Gunasegaram says like everybody else, banks should not be allowed to have their cake and eat it too.

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