Bank Conduct and Skin in the Game

The ancient code of Hammurabi had a law that if a builder built a house that collapsed and caused the death of the owner, the builder would be put to death.

Babylonian builders had Skin in the Game, the title of the latest book by the great writer on risk, Nassim Nicholas Taleb. Skin in the game, says Taleb, means that if you get the rewards, you must also take some of the risks, and not let others pay the price of your mistakes. It is not just about incentives; it is about “symmetry, more like having a share of the harm, paying a penalty if something goes wrong.”

Something seems to have gone wrong with conduct in Australia’s financial sector. The Royal Commission set up to investigate misconduct has found and exposed it. There are calls for paying penalties in the form of criminal prosecutions and “heads to roll”.

Part of the problem, some say, is that bank executives and directors don’t have (or have enough) skin in the game, and putting more skin in the game is being put forward as part of the solution.

BEAR

The Banking Executive Accountability Regime (BEAR) is one key reform in this area. The BEAR was announced in May 2017, before the Government finally decided to have a Royal Commission. It has now been legislated and will commence for the big banks from 1 July this year.

In his 2 May 2018 speech Beyond the BEAR Necessities, APRA Chairman Wayne Byres said that accountability “is probably the most important element of the BEAR. In many ADIs, there is often collective responsibility for various aspects of its business: for any given process or product, there are often hand-offs of responsibility (including, at times, to external partners and suppliers). But this creates the risk of collective responsibility leading to no individual accountability. Clarity of accountability – the foundation of the BEAR – goes to the heart of a strong risk culture.”Mr Byres said that the BEAR “will therefore mean accountable persons have more skin in the game for a longer period of time than is typically the case now and will place greater pressure on ADIs, when adverse prudential outcomes occur, to explain how that has been factored into remuneration outcomes.”

CBA prudential inquiry

Only the day before Mr Byres’ speech, APRA had released the report of the prudential inquiry into CBA, which looked at accountability in the CBA, as well as governance and culture.

The CBA review panel reported that a lack of accountability was a common theme underlying several of the issues observed in its inquiry. The panel assessed CBA as having a poor track record in relation to accountability, and found that the level of accountability observed fell a long way short of the standard set by its own delegations policy. Issues with accountability contributed to an inability to identify who was accountable when things went wrong, inadequate remuneration outcomes for adverse risk and compliance outcomes, weak issue escalation management and closure, insufficient oversight at the executive committee level, and inadequate business unit supervision of functions performed elsewhere in the group.

One of the report recommendations is that CBA senior leadership should have “‘skin in the game’ and adequate time commitment to perform program director or oversight roles, rather than relying on external parties to provide leadership.”

The panel found that there were “significant weaknesses” in the implementation and oversight of the remuneration process in CBA, particularly for adjusting remuneration as result of poor risk and customer outcomes. CBA has withholding of variable remuneration that has been earned but not paid (known as ‘malus’ – the opposite of bonus), but the panel found that there were no formal mechanisms to retrieve payments that have been earned and actually paid (known as ‘clawback’).

Boards and shareholders

The fallout from the Royal Commission at AMP has led to a number of directors resigning, prompting commentary from many quarters on the role of directors of large financial institutions in the current troubles.

Writing in The Weekend Australian of 5-6 May 2018, Judith Sloan says of directors that “few if any have any real skin in the game – by owning a large number of shares, for instance – which often leads to cavalier attitudes when it comes to spending other peoples money, in this case the company’s, and the taking of risks”.  Sloan says that the solution to the undesirable corporate governance arrangements is for “boards to return to the basics, by focusing on achieving good returns on capital through the sale of excellent products and services to customers.”

Once upon a time, bankers put their own money on the line. The Bank of England’s Andy Haldane gave an influential paper in 2011 in the aftermath of the GFC, Control Rights (and Wrongs), looking at how governance of banks has changed since the 19th century.

In the mid-19th century, he said, “the United Kingdom had around 500 banks and 700 building societies. Most of the former operated as unlimited liability partnerships, the latter as mutually-owned co-operatives. Bank balance sheets were heavily cushioned. Equity capital often accounted for as much as a half of all liabilities, while cash and liquid securities frequently accounted for as much as 30% of banks’ assets. Banking was a low-concentration, low-leverage, high-liquidity business … This governance and balance sheet structure was mutually compatible. Due to unlimited liability, control rights were exercised by investors whose personal wealth was literally on the line. That generated potent incentives to be prudent with depositors’ money. Nowhere was this better illustrated than in the asset and liability make-up of the balance sheet. The market, amorphously but effectively, exercised discipline.”

Since then, Haldane said, “the risks from banking have been widely spread socially. But the returns to bankers have been narrowly kept privately. That risk/return imbalance has grown over the past century. Shareholder incentives lie at its heart.”

Regulation

Regulators are also in the spotlight, and the question being is asked why they have not done more.

It would be unfortunate but predictable if the outcome of the Royal Commission was yet more regulation and funding for regulators. There are already plenty of laws against misconduct in the financial sector. If there is not enough law enforcement, there are certainly enough – or even too many – laws for regulators to enforce.

Another writer at The Australian, Adam Creighton, has weighed in on the debate. Forget about trust and culture, he wrote recently: the only way outcomes will change is if there are changes to the incentives for regulators and individuals working in financial services. “Why not”, he asks, “give regulatory staff bonuses for successful prosecutions of corporate crime?” That’s more an incentive than pure skin in the game, but for symmetry Creighton also proposes a ban on financial regulators working for financial institutions in the future.

Nassim Taleb is sceptical about more regulation as a way of controlling large corporations. He says that regulations can be gamed and lead to predation by the state, its agents and their cronies.

Taleb argues that the other solution is “to put skin in the game in transactions, in the form of legal liability”: if you harm me, I can sue you.

Perhaps a better fix, then, is to more effectively enforce existing laws, rather than create a raft of new obligations. In the United States, litigants acting as “private attorneys general” are an important adjunct to government regulators, giving those affected by misconduct the means to take direct action to enforce their statutory rights. A growing body of class actions in Australia is developing a similar approach, but corporate class actions here are still very focussed on recovery for allegedly aggrieved shareholders.

Patrick Dwyer and Kathleen Harris

Legal Directors