UK: Lord Myners on bank governance, remuneration and communitarianism

Lord Myners, the Financial Services Secretary, delivered a speech last Friday titled "Developing a new financial architecture: lessons learned from the crisis" at the Financial Times Global Finance Forum. The wide-ranging speech has attracted much attention in the newspapers (see here and  here). With regard to governance - one of several topics covered in the speech - Lord Myners had some strong words, particularly with regard to remuneration in banks. It is well worth quoting this part of his speech in full:

It is critical that we have effective corporate governance – failures of corporate governance were after all a material contributor to the financial crisis. Company directors must make decisions based on long-term performance considerations; investment managers must engage with the companies in which they invest and hold them to account when they fail to think long-term; shareholders, for instance pension fund trustees, must ensure that their managers are appropriately incentivised to engage and held to account when they don’t.

Shareholders must take front-line responsibility for the companies in whose equity they have invested their client funds. Shareholders have previously spoken of their concerns that there were structural impediments to effective engagement. Therefore I welcome the recent announcements by the FSA [here] and the Takeover Panel [here] that their rules do not constitute an impediment to effective collaborative engagement by like-minded shareholders. There is no structural or regulatory obstacle to the pursuit and delivery of effective stewardship. But does the will exist for shareholders and trustees to take seriously their fiduciary and legal responsibilities? Sir David Walker will have more to say on this.

Firms too need to show leadership if they are to regain the public’s trust. This applies to everyone in the governance chain, including banks and their boards. It is time for banks to explain to the public what contributions justify the ever-growing rewards of derivatives traders, speculators and other inhabitants of the so-called casino end of the industry. Where those justifications cannot be easily made, tough questions need to be asked by boards and shareholders. Also, directors and senior management need to take full and explicit responsibility for Risk. Walker is proposing a Board Risk Committee. Good. The challenge to put to the banks is they should not approve new products or engage in complex strategies without the fullest possible understanding of Risk and economic purpose. The government and the regulator cannot do that for them. Clearly that challenge was not always properly applied prior to the crisis.

For obvious reasons, the issue of remuneration is a sensitive one. For some the only answer is to ban bonuses outright, for others, a bank in a free market should be able to pay as it pleases. There is an irony in the labour market not working effectively at the heart of financial markets; the citadel of market efficiency. Supply is not responding to pricing signals. If some activities like proprietary trading are so profitable, banks clearly have an economic incentive to participate, provided risks are properly controlled and regulation complied with. But why do banks appear to be allowing a disproportionate share of surplus to pass to employees? Do these employees really have unique talents, or are they largely reliant on the banks' capital and franchise and the banks' knowledge, from order flow? Logically, the banks would 'institutionalise knowledge', and nurture pools of talent to reduce dependence on individual talent; writing it down and building bench strength. And yet they do not appear to have done this. Derivative traders are not footballers with unique talents, and should not be paid as though they are. Bank owners, our pensions and savings, are possibly being short-changed by ineffective governance and stewardship.

And why do M&A bankers get so hugely rewarded? What skill do the members of this small elite community have which cannot be replicated by others? I suspect a great deal has to do with the authority of the investment bank’s brand – which begs the question why individual bankers frequently pocket 50 per cent or so of the fee charged by the bank to clients. Some get bonuses in excess of £10million per annum (and not always for advising on transactions which deliver all they promise, as we have seen in banking sector transactions in recent years). Why hasn't the market mechanism adjusted pricing? What is frustrating a logical market response? If the market was working rationally, these rewards should have led to a sharp increase in supply and downwards pressure on margins.

These are not the only areas where market discipline doesn't appear to function at the heart of markets. Another example is equity underwriting or agency brokerage. Let me be clear: the primary responsibility for achieving rational outcomes lies with directors and shareholders. They need to explain why they are not pressing much harder, for instance, on fees at M&A or the costs of underwriting. For the Government, our focus in this area is on ensuring that bank remuneration is structured so that it rewards long-term value creation in an environment of rigorous risk control and regulatory compliance; not short-term and unsustainable illusory profit streams.

It is clear is that the prevailing bonus culture failed to take a long-term approach to risk allocation and capital protection. The public is rightly angered by what we have seen with bonuses and remuneration, and change is coming. Higher capital requirements (higher in the case of some activities by multiples rather than percentages) will serve to limit bonus pools for risky activities, reducing the profitability of many activities and dealing strategies, and the G20 has agreed to implement tough rules to ensure clawback and deferral of bonuses in addition to significantly enhanced disclosure of remuneration culture and structures.

There is another very important issue around remuneration: perceived fairness. Organisations with extreme distributions of income are inherently prone to greater instability. It is harder to foster shared values and common culture. It can be a source of risk. The national minimum wage is £5.73 per hour. That means that someone working for forty hours a week for forty-eight weeks a year earns £11,001.60 per annum. According to the Office for National Statistics' Annual Survey of Hours and Earnings (ASHE), "mean" gross annual earnings across all employee jobs in 2008 came to £26,020 and "median" gross annual earnings was £20,801, across all employee jobs. I sometimes think that Remuneration Committees and senior investment banking executives need to be reminded of this reality before they disgorge huge bonuses. And they have to ask themselves whether they have fully explored all options to protect organisational and shareholder interests before going down the route of making payments which many in society find unacceptable in terms of reward for skill and contribution.

We need to get the balance right between the individual and the firm, and the individual and society. Communitarianism emphasises the need to balance individual rights and interests with that of the community as a whole, and the fact that individual people are shaped by the cultures and values of their communities".