Thursday, 9 December 2010

UK: Lord Turner responds to criticism regarding RBS decision

Lord Turner, the chairman of the Financial Services Authority, has responded to criticism following the announcement that enforcement proceedings would not be taken against the former directors of Royal Bank of Scotland: see here. In his response, Lord Turner offers these thoughts on incentives in the banking sector:

Failure in banking, or even the threat of failure offset by public intervention, carries huge economic costs quite different from non-bank companies. In banking, moreover, higher return for higher risks is sometimes achieved not by socially valuable product innovation, but by leveraging up and taking liquidity risks, increasing the danger that society must clean up the mess.

The question is, should we reflect these fundamental differences in a more explicit recognition that the attitude of bank Boards and executives towards risk-return trade-offs should be different from in other sectors, and should we create incentives to adopt this different attitude? It would, for instance, be possible to set a rule that no board member or senior executive of a failing bank will be allowed to perform a similar function at a bank in future, unless they can positively demonstrate to the regulator that they warned against and sought to reduce the risk-taking which led to failure. Compensation-related rules could also be considered: the Dodd-Frank Act in the US introduces the principle that executives of banks which fail are liable to forfeit two years of past compensation if they were ‘substantially responsible’ for the decisions which led to failure.

Such automatic rules would not rely for their application on proof of specific inappropriate conduct. They would recognise that while the financial crisis entailed some instances of professional incompetence, recklessness and fraud, the more general problem was that some executives and Boards made risk-return trade-offs which might have been acceptable in non-banks, but were hugely harmful to society when made by banks.

Investigations focused on whether individual executives breached rules have a role and the FSA has successfully brought some enforcement cases relating to breaches revealed by the banking crisis. But achieving a general shift in attitudes to risk and return may require that bank directors and executives are made subject to quite different incentives than those which are appropriate in other sectors of the economy.

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