How to get rid of banking supervisors?

Central bankers are increasinly talking about culture, incentives etc. There have been two recent speeches which revisit these topics using bank supervision lens. First by Norman Chan of HKMA and second by Andreas Dombert of ECB.

Norman Chan of HKMA in this speech goes back to banking history when there were no banking supervisors:

If you can find a clock or time machine that would allow you to dial back time to 100 years or so ago, then you would find yourself in a happy world where there was little or even no banking supervision.  Contrary to common belief, banking supervision as a profession or industry (or, as some bankers would no doubt have it, a “black art”) does not have a very long history.  Until the Roosevelt New Deal era 1933 Banking Act in the USA, no depositor in an American bank could have been assured of clear supervisory oversight, following a century of uncertainty about state and national authority over banks and the issue of bank notes. 

In the UK, the first statutorily-backed regulatory regime was put in place only in 1979.  Prior to that time, the Bank of England had exerted only informal authority, including through the venerable “Governor’s eyebrow”.  Both the US and the UK Acts were prompted by preceding banking crises. 

In Hong Kong, the Office of the Commissioner of Banking was only established around 50 years ago in the 1960s, after a couple of rather unpleasant bank failures.  Before then, banking was basically a free for all, although it did not mean that it was a wild jungle ruled by Tarzan or the Lion King. 

Back in those “good old days” during which banking supervision was not a prominent feature of our financial system, bank customers and depositors had to take care of their own interests by choosing very carefully who they could trust and bank with.  It should also be borne in mind that internationally, the first Basel Capital Accord was only approved by the G10 Governors in 1988, meaning that we are only just approaching the 30th anniversary of this important milestone.

I know that you are going to say: you cannot find such a clock or time machine.   In that case, the fast track solution is not quite available.  So you will have to consider the slow track solution in trying to get rid of the bank supervisors.  As I said earlier, a world in which there were no banking supervisors was not a wild jungle.  For a long long time and well before we had bank supervisors, bankers needed to earn the trust of depositors and customers in order to survive and thrive.  Those who failed to earn the trust of customers would not and could not last long.  So by and large bankers who managed to survive were highly trusted and respected by the community in the “good old days”. 

Unfortunately this is no longer the case in recent decades, especially after the Global Financial Crisis (GFC).  So something has changed that has led to the erosion of trust in bankers.  Only if we can restore that trust, and the fundamentals underpinning it, could we have a meaningful discussion on the proposition of getting rid of the bank supervisors.

Hmm.. It is nice to hear when regulators themselves believe that free banking was not wild cat banking as we are made to believe. Yes banks failed but the better run banks continued to run and are amidst the oldest surviving organisations in most countries.

He further talks about how bankers earlier had skin in the game:

In the “good old days”, banks were often organised in the form of partnership and not as limited companies.  The owners or managers individually and collectively had their family wealth at stake in ensuring that the banking business was run not only profitably but also prudently.  Any mismanagement of the affairs of the bank could wipe out their family wealth and, in some instances, lead to imprisonment.  Any partner of a bank had the duty and right to warn against and take steps to constrain another partner from taking excessive risks, if such risks could bring down not just the culprit but all the partners who were jointly responsible for the well-being of the firm. 

In contrast, in modern times, banks operate predominantly in the form of limited companies, often listed on stock exchanges, with very diverse public ownership.  Senior managers who run the bank do not have most of their personal worth tied up in the firm and the prospects for life-long employment have become few and far between.  Nowadays (in particular during the period preceding the GFC), senior bank managers are generally rewarded by a combination of very high salaries coupled with very substantial annual bonuses tied to performance in the preceding year.  Even where share options are included in their remuneration packages, the lock up or vesting period is relatively short – just a couple of years at most.  The effect of this change is that the previously strong alignment of long term interest between bankers and customers has been materially weakened, leading to the classic situation of an agency problem, with the bank management using depositor funds to leverage up the scale of business while the downside risk that they face in doing so is limited. 

Another material change in banking from the “good old days” is the problem of what I call “short-termism” amongst some bank shareholders (“impatient capital” focused only on bolstering their own short-term returns).  It has also become increasingly common for senior bank managers, especially at the top levels, to be hired on contract basis.  While this might be justifiable from the point of view of hiring the best talent available in the market, it could have the unfortunate side effect of cultivating short-termism amongst senior bankers if they only work for a contract or two and therefore must deliver tangible and quantifiable financial results within a short period of time, such as a target RoE.  In essence, like football managers, they survive on their reputation for delivering fast results during the current league season.  

Hmm…

As going back to gold old days is not possible, we cannot even get rid of bank supervisors:

In summary, the slow track solution to get rid of bank supervisors involves quite a number of fundamental changes to counter those trends that arise from what is now practiced in modern day banking.  The measures required are not new, and are intended to restore a strong alignment of interest between bankers and their customers.  This would entail, as I have explained, the creation or re-creation of a balanced and fair compensation system for bank owners and senior managers in which good performance is rewarded and bad risk management or conduct is punished.  However, the crux of the matter is that the performance has to be long term and not short term.  To reduce the risks of senior managers and bank staff taking short-sighted decisions, longer term or even life-time employment should be encouraged and not discouraged.

I know what you are going to say!  You will say that I am asking for something that is very hard, if not impossible, to accomplish.  The world has changed so much that it is unrealistic to go back to the “good old days”.  For example, most banks are limited companies listed on stock exchanges and it is just not practical for them to return to a partnership structure.  Moreover, banks employ hundreds of thousands of staff at different levels and it is impracticable to insist on life employment for all of them.  Nor will employees in these modern times prefer to stick with one company for the whole of their working lives.  As for the short-termism of the shareholders and the financial reporting cycle, banks are at the receiving end and there is not much they can do.

While I agree that it is probably unrealistic to go back to the “good old days” of banking, I am not fully convinced that there is little banks can do to restore a stronger alignment of interest with their customers.  But that doesn’t really matter because, without these changes, the slow track solution to get rid of supervisors also does not seem to work!  So I am bringing you the bad news!  The bad news is that the public will need an agency entrusted with the mandate and powers to protect the safety of their deposits, to guard against banks taking excessive risk in pursuit of profits, to ensure that customers are treated fairly, to deal with bank failure, as and when it happens, in an orderly manner to avoid disrupting the financial system and reduce the risk of having to use public funds again to bail out failing banks.  What happened during the GFC is a very powerful reminder that excessive risk taking in pursuit of short term profits in modern day banking and finance can and did pose a serious threat to the economic well-being and stability of society as a whole, even in the most advanced economies. 

He says cultural change should be backed by fixing incentive structure as well..

Nice stuff.

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