AFTER last week’s turmoil in the markets, what could be done to make sure that
it never happens again? Here is our seven-point plan.
Scrap Britain’s system of finance regulation and replace it with
one that works, staffed by well-paid professionals
As the Northern Rock debacle proved, Britain’s unique, three-way system of
financial regulation, which splits responsibility between the Bank of
England, the Treasury and the Financial Services Authority (FSA), does not
work well in a crisis. It is cumbersome, does not give clear lines of
responsibility and can fall prey to factional infighting between the three
groups.
All of those failings were exposed when Northern Rock crumbled.
Sir Charles Goodhart, the Bank of England’s former chief policy adviser, had a
point when he said last week that perhaps HBOS could have been saved as an
independent lender if the Treasury had acted quicker to pump more money into
the system and offer emergency funds to ailing banks through Alistair
Darling’s special liquidity scheme.
“I wonder whether we would have needed to get into this state if the special
liquidity scheme had been allowed to continue earlier,” he said.
Gordon Brown has already admitted changes must be made. The government has put
the Bank in charge of monetary policy and it should get a wider role to
oversee market regulation too by merging with the FSA.
After all, it was the financial regulator that failed to keep on top of
liquidity when there was a run on the Rock last year.
This bringing together of two of the three legs of regulation would help to
clarify who is responsible for what when the next crisis arrives.
By itself, however, it does not tackle the perennial problem of financial
regulation — pay. Thanks to the huge difference in salaries between the
watchdogs (on civil-service pay grades) and the practitioners (on
master-of-the-universe pay grades), it is always an unequal battle.
“The dumbest guys in the market chase the smartest guys. There is always one
winner,” said one senior banker.
So those charged with ensuring orderly markets need to be paid in line with
those trying to subvert them.
What we need to avoid is an ineffective, knee-jerk reaction. The
Sarbanes-Oxley rules introduced in America after the Enron collapse
succeeded in tightening up on company disclosure.
That drove many international companies to move their stock-market listings
from New York to London, but it did not nothing to prevent the sub-prime
disaster.
Banks must stop paying big bonuses for short-term results
There is nothing wrong with big bonuses. What needs changing is big bonuses
that encourage short-term risk taking. Counting up the bonus pool on a
quarterly basis has bankers’ eyes bulging in anticipation of the end-of-year
payout. No wonder their judgment has been so flawed.
Giant payments are still being made for failure. Stan O’Neal, ousted from
Merrill Lynch, and Chuck Prince, removed from Citigroup last year, split the
best part of £110m, comfortably more than their peers who are still battling
to repair the balance sheets they left behind.
Remuneration should be pegged to longer-term profitability goals and the
bank’s share-price performance.
However, this alone does not always work.
At Lehman Brothers it was common for staff to take 50% of their bonuses in
shares. Not selling out was a badge of honour while people remained
employed. When the company collapsed, staff owned a third of the shares.
“You shouldn’t be paying out bonuses today for profits that don’t generate
cash in the future,” said Cliff Weight, a director at the remuneration
consultancy MM&K. “Bonuses should be risk-adjusted — the higher the risk,
the higher the trigger for bonuses to be paid.”
Weight believes chief executives should be tied in with incentives that pay
out over the longer term, rather than today’s typical three-year cycle.
Find better board members
Blue-chip boardrooms must not be a refuge for the old and irrelevant. During
the collapse of Northern Rock, much was made of chairman Matt Ridley’s
background as a scientist who researched the mating habits of pheasants.
Yet his pedigree — the third generation of his family to chair the bank — is
less esoteric than that of directors on Wall Street, where the old boys’
network is alive and well. Theatre producer Roger Berlind, 75, sat on the
board of Lehman Brothers for 23 years. Until two years ago, he was joined
for meetings by Dina Merrill, an 83-year-old actress who appeared in
black-and-white films alongside Katharine Hepburn.
AIG is little better. Martin Feldstein, 68, is a Harvard professor who has sat
on its board for 21 years. Ellen Sutter is president of the American Museum
of Natural History.
Carol Leonard, head of board practice at headhunter Whitehead Mann, thinks the
problem is not age, but access, and says non-executives must be encouraged
to take a more active role in company affairs.
“Rather than seeing them as a necessary evil that needs to be tightly managed,
boards are behaving more professionally than they used to towards
non-executives,” she said.
Restrict short selling
The practice of driving down stock prices in the hope of making a quick buck
has gone too far. It should be stamped out, or at least banned when
companies are most vulnerable, such as during a rights issue.
Last week 24% of shares in Washington Mutual, a troubled American savings and
loans bank, were out on loan, according to the stock-lending tracker Data
Explorers. Hedge funds borrow shares to sell in the hope that the price will
dive and they can buy them back at a lower price. It wouldn’t be so
widespread if pension funds didn’t lend their holdings so cheaply and
without asking more questions.
A clampdown is easier said than done. Companies use stock lending for more
legitimate reasons, such as when they are hedging currency.
However, the American watchdog, the Securities and Exchange Commission (SEC),
is already attempting to curb the practice with new measures that stipulate
short sellers and their broker-dealers must deliver securities on the
settlement date, three days after the sale.
Late last Thursday, the FSA joined in, banning investors from taking new short
positions in financial stocks until January 16. That caused last Friday’s
market bounce, which was accompanied by the smell of singed flesh as
shorters burnt their fingers. The FSA also wants daily disclosure of net
short positions above 0.25% from Tuesday and could expand the measure to
other industry sectors.
“We have been much concerned — as have many — at the volatility and what I
would describe as incoherence in the trading of equities, particularly for
financial institutions,” said FSA chairman Callum McCarthy. Now he needs to
work on a permanent solution.
Credit-ratings agencies should be overhauled
The man in the street may not have heard of Standard & Poor’s, Fitch and
Moody’s, but as the three main credit-rating agencies they play a vital role
in the working of the world economy. They asses a company’s credit
worthiness — in essence, whether it is good to pay back a loan. On the back
of their ratings, billions of pounds are advanced every day.
The credit crunch has revealed an obvious flaw in the system. The agencies are
paid not by those wanting an independent view, but by the companies being
rated.
The SEC has already launched a crackdown, finding evidence of “serious
shortcomings”. Staff at the agencies admit they struggle to keep up with the
volume and intricacy of complex debt securities. The problem is, they have
become a key part of valuing a stock. No matter what they claim, their
reports are merely opinions.
To tackle the basic problem, agencies should be reformed so they are paid
either by the group lending the money or by a general market levy that would
give a copper-bottomed guarantee of independence.
Shareholders should be more vigilant
Shareholders need to get a grip on what is happening inside the companies in
which they invest. Of course, the difficulty is that there is little
appetite to police success. And most investors, taking a short-term view,
prefer to sell their stock rather than engage with a company management with
which they disagree.
“It is probably true that there are aspects where shareholders could have done
more, but it’s very clear that the deficiencies must be shared around
regulators and the boards of banks as well,” said Peter Montagnon, head of
investment affairs at the Association of British Insurers.
“They are much closer to the situation than shareholders because of the
job they have and their access to information.”
Stop banks from over-borrowing
Consumers get fined when they breach their overdraft limit. Similarly, banks
need to have strict rules in place governing their capital requirements to
prevent them from overstretching.
HBOS had a strong balance sheet — right up until the moment it didn’t any
more. Leverage — the amount of debt piled into a deal — should also be
policed.
Regulating in this area is tricky. It should be measured, not knee-jerk, and
aimed at not stifling London’s place as one of the world’s financial
capitals.
The best way is through greater international co-operation using the Basel II
accords. They are recommendations made by a special committee to create
global standards.
A close look should also be taken at the yen carry trade — the practice of
borrowing yen at rock-bottom rates in order to finance the purchase of
higher-yielding assets.
