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Wednesday, June 16, 2010

Ongoing comments on Banking

Better than tying compensation to share performance, tie personal wealth to bank risk profile.

FT.com / Columnists / GillianTett - Ideas on curbing bankers’ appetite for risk:

"America’s vision of capitalism has tended to assume that the best way to run efficient companies is to give top executives incentives to maximise shareholder value, by linking pay to share prices.

But even if that creed works for non-financial companies, there is a basic problem with applying this principle to banks. The average non-financial company is composed of 60 per cent equity and 40 per cent debt. But at banks, leverage has been so high that debt can account for 95 per cent of value, and equity only 5 per cent.

Thus, if bank executives focus only on equity prices – say, by raising profits – but have less incentive to protect the long-term value of debt – most notably by creating a stable business – that creates a mismatch, particularly since bank debt is typically protected by governments. Or as a paper* recently co-authored by Mr Mehran says: “Structuring CEO incentives to maximise shareholder value in a levered form tends to encourage excess risk-taking.” Hence the credit boom."

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