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Home > Blogs > Ian Fraser > Robert Jenkins: Britain's banks must kick their RoE habit

Robert Jenkins: Britain's banks must kick their RoE habit

Britain's banks must kick their RoE habit Ian Fraser

Robert Jenkins, the Bank of England’s Financial Policy Committee member who last November famously slapped down UK bankers for lobbying  to water down reforms, has penned a brilliant column on what’s gone wrong with the banking sector and how it might be fixed.

His article - "Change Bank Pay Now" does't stray into convoluted arguments about Basel III or IFRS accounting technicalities, but focuses on the fact that banker's pay continues to be calculated using a flawed yardstick.

In the light of the scandal surrounding 'rewards for failure' and payment of obscene bonuses at state-owned banks RBS and Lloyds Banking Group and the sense of entitlement that persists on bank boards, Jenkins’ piece is well worth a read. It helps that Jenkins, a former chief executive of F&C Asset Management, who earlier worked at Citigroup and Credit Suisse, can write.

The full article, which originally published last October, is available from Reuters.com. Here are some choice passages:

Give an artillery commander the wrong target and the result is likely to be collateral damage. Give regiments of global bankers the wrong target and we should not be surprised by a similar outcome. This is what investors and board directors have done. Many bankers lapped it up. The result: considerable western wreckage.

Jenkins asks why some bankers did not adjust for risk? He says there can only be three options:

  1. They did not understand the risks they were taking;
  2. They understood the risks but prudence was not in their personal interests
  3. Investors egged them on

He then asks why institutional investors underestimated risk, and again suggests there three main answers:

  1. They didn't understand the risks banks were taking
  2. They listened to sellside analysts who did not adjust for risk
  3. They thought they would enjoy the ride while the music was still playing and be smart enough to exit before it stopped.

Jenkins goes on to describe the widespread “rent gouging” (also eloquently described by Andrew Smithers in his QFINANCE viewpoint) by which bankers continue to pay themselves unwarranted packages complete with egregious perks, even though share prices are flagging, profits are weakening, deceit about asset valuati0ns continues, abusive tax avoidance schemes are rife and tens of thousands of staff are being axed. The most notorious of a breach of corporate governance guidelines cam when Barclays paid off a £5.7bn tax bill for its boss Bob Diamond. For Jenkins many bankers exist on a warped form of welfare:

“For the longer term investor, many bank share investments have proved the equivalent of capital contributions to not-for-profit companies employing exceedingly well paid staff."

Jenkins would like to see banks banned from using return-on-equity as a performance metric and to adopt a more risk-adjusted approach. Jenkins is dismayed that banks continue to set EPS and RoE targets even though are known to incentivize potentially harmful behaviour including the quest for non-risk adjusted returns (which one of the reason banks gorged on US asset-backed securities and European sovereign debt during the credit bubble)  and to minimize their capital.

Jenkins believes institutional shareholders must start taking taking their responsibilities as owners more seriously and start forcing changed metrics and greater discipline on the banking sector. He wants the banks to align their remuneration policies with owners' interests and said the “accident-prone objectives” of the pre-crisis era must be scrapped and replaced them with a revised set of performance criteria that incentivize bankers "to do what many say they were doing but weren't building shareholder value”

Here, Jenkins is singing off very much the same hymn sheet as the Bank of England’s Andy Haldane.

Jenkins and Haldane both believe see return on assets (RoA)  as a viable alternative to the discredited metrics of RoE and EPS.  (Haldane recently started thinking further out of the box, imagining a disintermediated financial world where banks become irrelevant.) Jenkins pointed out that as a number of UK banks were heading for disaster in 2006-07, their return-on-assets was falling, even as their return-on-equity was falling. So if they had been using that as a performance indicator their deluded boards, might just have noticed that something  was awry.

Jenkins' described return on risk-weighted assets (RoRWA) as second alternative which might be preferable to RoA because it benefit of forcing a focus on risk.

“What risks are banks taking, in what areas and to what degree? RoRWA should prompt bank boards to ask the questions they have not been asking. But RoRWA is not without its shortcomings. A board that bets the bank on Basel-driven risk weightings is betting that Basel got it right.”

Jenkins warns there is no silver bullet but of one thing he is sure; that RoE is finished as a viable metric for banks. As Jenkins says, the pursuit of this particular holy grail has:

“Contributed to volatility of returns, excessive leverage, reckless risk-taking and systemic instability. It has NOT contributed to the creation of sustained or sustainable shareholder value. As a key motivator for bank behaviour, it has to go."

However I am not yet prepared to wager when this scrapping will occur. BTW, I'm grateful to Anat R Admati, a professor of finance at Stanford University, who alerted me to this.

Further reading on management incentives and how banks are sticking with the flawed ones:




Tags: Anat R Admati , Andrew Smithers , Andy Haldane , Bank of England , banking , Barclays , Basel II , blindness to risk , Bob Diamond , bonuses , Citigroup , Credit Suisse , F&C Asset Management , Financial Policy Committee , IFRS , incentives , leverage , Lloyds Banking Group , RBS , rent gouge , return on assets , return on equity , risk , risk management , Robert Jenkins , Royal Bank of Scotland , sellside research , Stanford University , UK , UK economy
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  1. per-kurowski says:
    Thu Mar 22 15:25:00 GMT 2012

    Robert Jenkins writes: “Banks target Return on Equity (RoE)… Have such targets produced attractive shareholder returns? No. Why? Because those concerned did not adjust for risk. Why did some bankers not adjust for risk? Three possibilities: 1) they did not understand the risks they were taking; 2) they understood the risks but prudence was not in their personal interests; or 3) Investors egged them on. Amazingly, Mr. Jenkins does still not get it. Of course the banks needed to consider RoE, how would they otherwise be able to conserve their jobs and their shareholders? The bankers did adjust for perceived risk, by means of their traditional tools, like the interest rate the amount lend and other terms…. But then came loony regulators and ordered them to also adjust their required capital/equity to the same perceived risks… and so the banks simply overdosed on perceived risks. And the result of that regulatory stupidity are now the obese bank exposures to what is or was officially perceived as absolutely not risky, like triple-A rated securities and infallible sovereigns, and the anorexic exposures to what is officially perceived as risky, like the lending to small businesses and entrepreneurs. Occupy the Basel Committee and other bank regulators! http://bit.ly/dFRiMs

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