Andrew G Haldane: Control rights (and wrongs)
Text of the Wincott Annual Memorial Lecture by Mr Andrew G Haldane, Executive Director,
Financial Stability, of the Bank of England, Westminster, London, 24 October 2011.
* * *
The views are not necessarily those of the Bank of England or the Financial Policy Committee. I would like to
thank Evangelos Benos, Fergus Cumming, Jonathan Grant, Sam Harrington, John Lane, Iryna Kaminska, Priya
Kothari, Fiona Mann, Vasileios Madouros, Roland Meeks, Joseph Noss, Peter Richardson, Victoria Saporta,
Rhiannon Sowerbutts, Mervyn Tang, Matthew Willison and Peter Zimmerman for comments and contributions.
Introduction
It is a great pleasure and privilege to be presenting this year's Wincott lecture.
Banks are special. That has long been recognised in the design of their ownership,
governance and regulation. This special status can have strange consequences. The
historical distribution of risks and returns in banking is one. For a century, both risks and
returns have been high. But while the risks have typically been borne by wider society, the
returns have been harvested by bank shareholders and managers.
The experience of the past two decades illustrates well this imbalance. In 1989, the CEOs of
the seven largest banks in the United States earned on average $2.8 million. That was
almost 100 times the median US household income. By 2007, at the height of the boom,
CEO compensation among the largest US banks had risen almost tenfold to $26 million. That
was over 500 times the median US household income.1 Those are high returns by any
measure.
But so, subsequently, have been the risks. The fall in the share prices of global banks means
they are scarcely different in real terms today than in the early 1990s. And it is not just
investors licking their wounds. So too is the global economy. Temporary support for the
global banking system during the crisis peaked at around a quarter of global GDP. The
permanent damage to world GDP from the crisis is still being counted, but is likely to be
several multiples of that.
These oddities in the distribution of risk and return are deep-rooted and long-lived. They
have grown in waves over a 150-year period, originating in a set of reforms in the mid-19th
century aimed at lowering the cost of capital. They were swelled during the 20th century by
the emergence of institutions too big to fail. And during the 21st century investor and
managerial short-termism resulted in these waves reaching tsunami proportions. In 2007,
this wave broke with devastating consequences still being felt today.
This century-long evolution in banking occurred for understandable reasons; it was no-one's
"fault". But it has also unearthed a governance fault-line. Ownership and control rights are
exercised by shareholders. But for banks, equity is a vanishingly small fraction of their
balance sheet. Worse still, equity-holders often have risk-taking incentives out of line with the
interests of other bank stakeholders, much less society. This fault-line lies at the heart of the
imbalance between privatised returns and socialised risks. Only in banking do control rights
and incentive wrongs combine so uncomfortably.
That calls for fundamental reform. Post-crisis that has been recognised, as regulatory reform
has come thick and fast. These reforms are unquestionably a step in the right direction. But if
they are not to reappear, deep-rooted incentive problems in banking need to be tackled at
source. I wish to argue there is unfinished business before these incentives are properly
aligned with the public good.
Limited liability
In the first half of the 19th century, the business and governance of banking was relatively
simple. By the mid-19th century, the United Kingdom had around 500 banks and 700 building
societies. Most of the former operated as unlimited liability partnerships, the latter as
mutually-owned co-operatives.2 Financial sector assets represented less than 50% of annual
GDP and the largest banks had assets of less than 5% of GDP.
Bank balance sheets were heavily cushioned. Equity capital often accounted for as much as
a half of all liabilities, while cash and liquid securities frequently accounted for as much as
30% of banks' assets. Banking was a low-concentration, low-leverage, high-liquidity
business. A broadly-similar pattern was evident across banking systems in the United States
and in Europe.
This governance and balance sheet structure was mutually compatible. Due to unlimited
liability, control rights were exercised by investors whose personal wealth was literally on the
line. That generated potent incentives to be prudent with depositors' money. Nowhere was
this better illustrated than in the asset and liability make-up of the balance sheet. The market,
amorphously but effectively, exercised discipline.
It was given a helping hand by market-based prudential safeguards. Directors of a bank had
the capacity to vet share transfers, excluding owners without sufficiently deep pockets to
bear the risk. Shareholders also maintained their liability after the transfer of their shares.
This put shareholders firmly on the hook, a hook they then used to hold in check managers.
Managers monitored shareholders and shareholders managers. In this way, the 19th century
banking model aligned risk-taking incentives.
But the global environment was changing. During the first half of the 19th century, rich
countries were becoming hungry for capital to finance investment in infrastructure, including
railways. As long as capital in banks was restricted to a small number of unlimited liability
partners, credit was constricted. In 1826, the 6-partner restriction on UK banks was lifted,
allowing banks to operate as joint-stock companies. No longer was ownership and control
vested in a single agent.
But pressures were building to liberalise further. Unlimited liability became the next target. In
the words of British parliamentarian William Clay, "unlimited liability has a tendency to deter
persons of fortune, intelligence and respectability from becoming partners or managers".3
Shareholder discipline was proving rather too effective as a brake on risk-taking. One
obvious solution was to limit shareholder liability. This, it was felt, could broaden and deepen
the pockets of the investor base, freeing up bank capital and credit.
The United States had been an early-adopter, with Connecticut and Massachusetts
permitting limited liability from 1817. Neighbouring states had quickly followed suit. Although
limited liability had existed in parts of Europe from the 17th century, it was only during the
second half of the 19th century that its tentacles spread widely.4 In the UK, wholesale change
came with the Limited Liability Act and Joint Stock Companies Acts of 1855 and 1856.
Interestingly, banking was slow off the mark. Limited liability status was at first not taken up
enthusiastically. Bankers appeared to prize unlimited liability. It served as a safety certificate
for depositors, a badge of prudence. "A depositor would be much more likely to trust his
money with a bank whose shareholders he knew must yield up to him the uttermost farthing".
This from the lips of a banking expert of the day.5
But unlimited liability in banking remained under attack. Walter Bagehot believed its risk
benefits were illusory as many shareholders did not possess so much as the "uttermost
farthing". Bagehot believed unlimited liability generated its own incentive problem: the
wealthy assumed too much risk for the control they could exercise, dissuading them from
investing (Bagehot (1873)).
The collapse of the City of Glasgow bank in 1878 shifted the debate decisively Bagehot's
way. In one sense, this failure was evidence of the power of unlimited liability: no depositor
lost a penny. But 80% of the bank's shareholders were bankrupted and many made
destitute. As the Economist observed at the time, "the share lists of most of our banks exhibit
a very large - almost an incredible - number of spinsters and widows".6 Bagehot's incentive
problem was real. Public and parliamentary opinion quickly shifted.
The Companies Act 1879 facilitated conversion to limited liability. Between 1849 and 1889,
the number of unlimited liability British banks fell to just 2.7 Even then, some of the incentive
benefits of unlimited liability were preserved. Shareholder vetting remained in bank deeds.
And in place of unlimited liability, UK banks moved to a regime of extended liability. This was
the contingent capital regime of its day.
Extended liability typically had two elements - reserve liability and uncalled capital. Under
reserve liability, existing shareholders were liable for additional capital in the event of
bankruptcy. By 1884, British banks had reserve liability of around three times their paid-up
capital.8 This placed them on a similar footing to US banks, which had adopted a system of
double liability in 1863.9
Reserve capital was augmented by a pool of uncalled capital. This could be tapped
preinsolvency at the discretion of bank management. On average between 1878 and 1913, UK
banks had uncalled capital larger than their called capital (Grossman and Imai (2011)).
Together, reserve and uncalled capital made for a deep contingent capital pool for even
limited liability banks, amounting to as much as 50% of banks' liabilities.
With big money on the line, extended liability kept bank shareholders and managers on their
toes. Risk monitoring incentives remained sharp and risk appetites blunt. In the US, banks in
states with higher-multiple extended liability regimes typically assumed less balance sheet
risk (Grossman (2001)). The same was true of UK banks with high proportions of uncalled
capital (Grossman and Imai (2011)).
For a time, extended liability seemed to strike a reasonable risk-taking balance. But entering
the 20th century, that balance was again about to tilt. Consolidation was underway in banking.
Between 1825 and 1913, the number of English and Welsh banks fell from over 600 to
around 70.10 As the industrial structure of banking adapted, vetting of shareholders became
impractical. In an echo of today, it was argued that these larger institutions were better able
to diversify away their risk.
Extended liability had also shown itself to be ineffective in dealing with banking failure. In
crisis, exercising the capital option had heightened panic, not diminished it. As the Bank of
England's Deputy Governor remarked, "today a bank could not in a crisis make a call on
shareholders without aggravating the crisis" (Turner (2009)). By the end of the 1930s, there
were only six British banks left with reserve liability.
In the US, a similar process was underway. Systemic bank failure during the Great
Depression was taken as evidence of the inadequacy of extended liability in protecting
depositors. As in the UK, making a call on shareholders was deemed likely to make a bad
situation worse. It was quickly replaced with Federal deposit insurance in 1934. With reserve
liability gone, so too did the rationale for shareholder vetting.
So by the 1930s the governance and balance sheet structure of banks was unrecognisable
from a century earlier. Ownership and control were amicably divorced. Ownership was
vested in a widely dispersed set of shareholders, unvetted and anonymous. Their upside
payoffs remained unlimited, but their downside risks were now capped by limited liability. The
pool of reserve capital had largely evaporated.
Later in the 20th century, these governance and balance sheet features spread across the
financial system. During the 1990s, many of the larger global investment banks abandoned
their private partnership status to become limited liability public companies. In the UK, a
number of mutually-owned building societies followed suit and turned public. The rationale
was familiar from a century earlier - the desire to break their balance sheet chains. By the
end of the 20th century, joint stock banking was pre-eminent.
What impact did these governance changes have on banks' risk-taking incentives? Finance
theory here is admirably clear. In particular, we can draw on a framework developed a
century after the introduction of limited liability - the contingent claims model of Nobel
Laureate Robert Merton (1974). This tells us that the equity of a limited liability company can
be valued as a call option on its assets, with a strike price equal to the value of its liabilities.
Figure 1 demonstrates this option-like payoff profile to holding a hypothetical bank's equity.
The beta of a firm is measure of how its value varies with the market as a whole.
Arithmetically, the beta of a bank's equity is the product of its leverage and the beta of its
assets.11 So assuming an asset beta of 0.1 and a leverage ratio of 10, the bank's equity beta
will be equal to one. The returns on bank equity and the return on the market will then lie on
a 45 degree line, provided returns are positive. When market returns are negative, however,
returns on bank equity will not follow them south. Instead they will be capped by limited
liability.
This asymmetric payoff schedule generates interesting incentives. The value of the equity
option is enhanced by rises in the volatility of the bank's assets. Why? Because volatility
increases the upside return without affecting the downside risk. If banks seek to maximise
shareholder value, they will seek bigger and riskier bets. Joint stock banking with limited
liability puts ownership in the hands of a volatility junkie.
How has the junkie responded to these incentives? Chart 1 plots the distribution of the ratio
of UK bank assets to nominal GDP since 1880, broken down into sub-samples. Over this
period, this ratio has risen roughly tenfold. It has increased particularly strongly over the past
30 years, peaking at well over 500% of GDP. Other developed countries have experienced a
similar, if less dramatic, pattern. This is the "bigger bet" strategy in practice, as a route to
higher equity returns.
Historically, there is also evidence of the "riskier bet" strategy having been deployed to boost
returns. Chart 2 plots the distribution of returns on banks' assets, again broken down by sub-
sample. The mean return on bank assets lies in a range of 0.5-1% per year. But the variation
in returns has risen dramatically. Asset returns were two and a half times more volatile at the
end of the 20th century than at the beginning.
This evidence is no more than circumstantial. But it does point clearly to banks having
assumed greater risk in greater size as the disciplines of unlimited liability were progressively
relaxed. In other words, the historical evolution of banking is entirely consistent with the
predictions of Merton's theoretical model.
Debt and taxes
There is a second, and simpler, route to boosting equity returns. That is by gearing-up the
balance sheet. Increased leverage acts directly on a bank's equity beta. For example,
doubling leverage from 10 to 20 generates a new, steeper payoff profile of returns (Figure 2).
These are then even more asymmetric. Leverage allows shareholders to profit more
significantly when the market turns up, while still avoiding the downside when it turns down.
From Merton, this strategy enhances shareholder value.
Looking over a sweep of history, there is evidence of banks pursuing just this leverage
strategy. Chart 3 plots the distribution of UK banks' leverage since 1880. As unlimited liability
was phased out, leverage rose from around 3-4 in the middle of the 19th century to around
5-6 at its close. As extended liability was removed, leverage continued its upward trend into
the 20th century, by its close reaching over 20. Seven years into the 21st century, at its
highwater mark, leverage hit 30 or more.
This leverage strategy can be seen even more vividly in the distribution of returns to bank
equity over the past century. As Chart 4 illustrates, having begun the 20th century in modest
single figures, equity returns were averaging close to 20% by its end. At the height of the
boom, equity returns touched 30%. Arithmetically, virtually all of this increase in equity
returns can be explained by increased leverage.
And it has come at an obvious cost - greater risk. That, too, is clear from the empirical
distributions. Over the past century, the variability of returns on bank equity has risen
between six and sevenfold. The lower tail of equity returns has also been fattening.
Consistent with the predictions of Merton's model, a leverage strategy has simultaneously
boosted risks and returns to holding bank equity.
Chart 5 summarises this strategic evolution in banking over the past century of so. It is based
on a simple calibration of the Merton model. Leverage is shown along the x-axis and return
on equity along the y-axis. The lines are iso-volatility contours, drawn for different levels of
underlying asset volatility. Banking has migrated in a North-Easterly direction, as banks have
assumed greater asset risk and higher leverage. In the Merton framework these strategies
raise equity returns, precisely as we observe in practice.
There is a second, largely silent, factor that contributed to this century-long rise in bank
leverage - tax. Debt interest costs tend to be tax-deductible from profits in most developed
countries. But the cost of equity financing is not typically tax-deductible. This biases
corporate financing towards debt and away from equity.
This tax non-neutrality is hardly new. In the UK, it dates back more than a century. Tax
legislation for interest and dividends was first established in the UK in 1803. Throughout the
19th century, however, neither dividends nor debt interest were automatically deducted from
profits when calculating company tax. Payments to debt-holders and shareholders were
made net of tax and, roughly-speaking, treated equally.
This equal treatment was justified on the grounds that the profit of a business should not be
affected by its method of financing. In Anglo-Continental Guano Works v Bell (Surveyor of
Taxes), Mr Justice Cave summed up thus: "It seems to me... that the gains of the trade are
quite independent of the question of how the capital money is found... [One] cannot take into
consideration the fact that the firm or trader has to borrow some portion of the money which
is employed in the business... If you did that it would land you in very extraordinary results".12
Indeed, it might land you in the guano.
But banking was about to buck this trend. In Farmer (Surveyor of Taxes) v Scottish North
American Trust, Limited, Lord Atkinson referring to the Anglo-Continental case concluded: "It
does not appear to me that the reasoning on which this decision is based can apply to a
bank whose business is the borrowing and lending of money".13 From early in the
20th century, debt interest became a legitimate deductible from bank profits. Where banks
led, non-financial firms followed. This debt bias has persisted in the century since.14
The scale of tax-induced debt bias is generally greater the higher the rate of corporation tax
and the lower the rate of personal taxation of equity. The IMF (2009) has recently estimated
the scale of debt bias in a selection of developed countries. For low or tax-exempt investors,
such as pension funds and non-residents, debt is typically between 30-40% cheaper than
(new or retained) equity.15 For high-tax investors, the biases are smaller but still significant.
Differences on this scale provide strong tax-based incentives to increase leverage. They also
generate strong incentives to simultaneously avoid tax and arbitrage regulation. One recent
example was hybrid bank capital instruments. These counted as capital for regulatory
purposes, but benefitted from interest deductibility for tax purposes. In short, they were
winwin. The UK hybrids market grew to around $100 billion between 2000 and 2007. By then,
they accounted for around 25% of UK banks' tier 1 capital.
Up until the 1990s, empirical evidence had tended to find little effect of tax on firm leverage
(Graham (2008)). But a raft of recent studies has found tax effects on corporate financing
behaviour which are both statistically and economically significant. Pooling the results from
existing studies, de Mooij (2011) finds a marginal tax elasticity of 0.28. In other words, a fall
in the tax shield by 10 percentage points would lower the debt-to-asset ratio of a typical firm
by 2.8 percentage points.
This elasticity is based on a range of firms with an average debt-to-asset ratio of 0.5. Banks
rely much more heavily on debt, which provides closer to 95% of their financing. That would
imply a marginal tax elasticity closer to 0.5 - double that for non-financial firms. At these
levels, tax biases are likely to have had a material amplifying effect on bank incentives to
increase leverage.
Debt and discipline
In principle, these balance sheets risks (higher asset volatility and leverage) ought to have
had a natural counterweight - the disciplining effect of debt. Although they are second in the
risk-bearing queue, debt-holders as well as equity-holders would be expected to shoulder,
and hence price, this balance sheet risk. This could be done either by raising its cost or by
restricting its quantity. Either way, debt would then serve as a restraining device on
riskhungry, rent-seeking shareholders.
In theory, this debtor discipline mechanism ought to work like a dream. Under the
assumptions of Modigliani and Miller (1963) (MM), the pricing of risk by debt-holders ought to
neutralise fully any effect of increased leverage on the value of the firm. Provided
shareholders maximise firm value, and the world behaves according to MM, debtor discipline
ought to defuse completely incentives to gear-up.
Figure 3 illustrates the point diagrammatically, showing payoffs to debt and equity. They are
a mirror-image. The downside risk avoided by equity is assumed by debt and vice-versa for
upside returns. In principle, then, combining debt and equity would lead to offsetting payoffs,
neutralising risk-taking incentives.
During the 19th century, debt appears to have played just this role. Depositor flight and bank
runs came thick and fast, operating as an effective disciplining device on shareholders and
managers. That is why unlimited liability remained a prize asset until the end of the
19th century. This quasi-disciplining role of debt persisted up to the Great Depression.
Calomiris and Mason (1997) find that debt and equity prices did a reasonable job of
distinguishing good and bad banks during the Chicago banking panic of 1932. Indeed, they
signalled distress fully six months prior to banks' failure.
As the 20th century progressed, however, evidence of debt disciplining became patchier.
Studies in the 1980s typically failed to find balance sheet risk having a significant impact on
banks' subordinated debt spreads (Gorton and Santomero (1990)). Evidence from the 1990s
was more encouraging (Flannery and Sorescu (1996), Morgan and Stiroh (1999)). But even
then the link was weaker among larger banks, with little evidence of market prices influencing
banks' risk decisions (Bliss and Flannery (2002)).
Nowhere was the ineffectiveness of debtor discipline better illustrated than in the run-up to
the recent financial crisis. Chart 6 plots CDS premia for a sample of 33 large international
banks over the period 2002 to 2011. It partitions the sample into "crisis" and "no crisis"
banks, where the former are institutions subject to government intervention during the crisis.
CDS premia for all banks fell dramatically between 2002 and 2007, on average by around
three-quarters. Market perceptions of risk were falling at precisely the time risk in the system
was building. There was also little market differentiation between the spreads of "crisis" and
"no-crisis" banks: their average pre-crisis spread difference was a mere 8 basis points.
The extent of risk mispricing is clear from the movements in CDS premia as the crisis broke.
Average spreads rose by a factor of over 50 for "no crisis" banks. For crisis banks, they rose
by a factor closer to 70. Adjustments on that scale are a decisive rejection of the debt
disciplining hypothesis. Debtors were meant to act as a brake on risk-taking incentives.
Instead they had served as an accelerator.
Why? The answer again lies in incentives - the incentives of bank managers and policy
authorities. These incentives matter most at crisis time. Then, it may no longer be in the
interests of either bank management or the authorities to have debtors bear risk. Doing so
may run the risk of making a bad crisis situation worse. As much as bank management and
the authorities may pre-commit to debtor's bearing risk ex-ante, they may be tempted to
capitulate ex-post.
Economists call this a time-consistency problem. Agents cannot credibly commit to stick to
their guns in the midst of war. Private contracts for bank debt and public policies towards
bank debt suffer from a severe case of this time-inconsistency problem. Having debtors
assume pain is fine on paper. But crisis wars are not waged on paper. And if debtors
recognise that risks in contracts will not be enforced, they will no longer have incentives to
price risk and exercise discipline themselves. So it has been for well over a century.
There are many examples of time-inconsistencies in the private debt contracts issued by
banks. Uncalled capital and reserve liability were banks' loss-absorbing contract of choice in
the late 19th and early 20th centuries. They ultimately proved ineffective and were abolished.
Why? Because managers feared that invoking these instruments, at precisely the time they
were most needed, might make a bad situation worse. This is time-inconsistency writ large.
A century on, hybrid bank debt instruments fell into the same trap. They gave bank
management the option to rollover debt automatically in the event of stress. In principle, this
option had insurance value in a situation of liquidity stress. In practice, facing the liquidity
crunch of 2008, banks failed to exercise this option at just the point it was most valuable.
Why? Because they too feared scaring creditors and making a bad liquidity situation worse.
Hybrid debt, too, was time-inconsistent.
Time-inconsistencies in public policies regarding bank debt have been every bit as acute.
Both liquidity and deposit insurance have a long and revealing history. Liquidity insurance by
the central bank was firmly established in the UK by the end of the 19th century and spread to
all major central banks during the course of the 20th century. Deposit insurance started life
later in the US in 1934, but has since spread to most major developed countries.
The recent financial crisis illustrates perfectly the time-consistency problems both policies
face. Pre-crisis, deposit and liquidity insurance were enshrined in a well-defined regime. But
in the teeth of crisis, these regimes were abandoned. Liquidity and deposit insurance was
offered in close to unlimited amounts in most countries to protect confidence among bank
creditors, whether retail or wholesale. Prior policy commitments proved time-inconsistent.
This is a pattern familiar for well over a century (Alessandri and Haldane (2009)).
These time-inconsistency problems, private and public, have been made more acute by a
dramatic structural shift in the industrial organisation of banking over that period. This has
seen the emergence of leviathan institutions too-big-to-fail. At the start of the 20th century, the
UK's largest 3 banks' assets accounted for 7% of GDP (Chart 7). By the middle of the
century they had reached 27%. By its end, they had reached 75%. By 2007, assets of the big
3 banks had risen to 200% of GDP. Other countries tell a similar tale. Size and concentration
in banking has hit the roof.
Too-big-to-fail heightens the time-consistency dilemma for managers and policymakers. Big,
connected firms increase the chances of a bad situation turning not just worse but
catastrophic. Knowing the authorities will shoulder that tail risk, debt-holders will not price it
for themselves. That is doubly unfortunate, as it means debtor discipline will be weakest
among institutions for whom society would wish it to be strongest. Worse than that, bigger
banks will then benefit from an implicit state subsidy, for cheaper debt means fatter profits.
That might itself encourage further risk-taking.
There has been considerable recent interest in the scale of this too-big-to-fail subsidy.
Indeed, eliminating this subsidy has been taken as a bellwether of the authorities' success in
tackling the too-big-to-fail problem (Treasury Committee (2010)). Various attempts have
been made to quantify this subsidy (Oxera (2011), New Economics Foundation (2011),
Haldane (2010)). The two most popular approaches use credit ratings or option-implied
distributions.
The ratings-based approach looks at the difference between the standalone ("no support")
and "support" ratings of a set of banks. It uses this difference to determine how much higher
funding costs would have been in the absence of support (Haldane (2010), New Economics
Foundation (2011)). The options-based approach builds on Merton's framework
(Kou (2004)). A distribution is fitted to banks' assets. Whenever assets fall below a certain
threshold, the probability of government support can be estimated.
Table 1 looks at some empirical estimates of the implicit subsidy using the two methods, for
a sample of the four largest UK banks and 22 large international banks. The estimates are
shown over the period 2007-2010. For UK banks, under either measure, the implicit subsidy
amounts to at least tens of billions of pounds per year, often stretching to three figures. For
the global banks, the subsidy is worth at least hundreds of billions of dollars per year, on
occasions four figures.
These numbers are eye-popping. To give some context, they are a large chunk, and
sometimes exceed, the measured valued-added of the financial sector to annual GDP.
Recent revisions to support ratings do little to make a dent in them. Because they measure
risk mispricing by bank debtors, they capture the extent of dilution in debtor discipline arising
from time-inconsistency. The scale of subsidy suggests there is a considerable distance to
travel before debtor discipline could be fully effective in checking risk-taking.
Short-termism and performance targets
The story so far. Ownership and control rights for banks are vested in agents comprising less
than 5% of the balance sheet. To boost equity returns, there are strong incentives for owners
to increase volatility. Those risk-taking flames have been fanned by tax and state aid. As
stories go, this one sounds grim.
But this story also contains a puzzle. Long-term shareholders in banks have not obviously
reaped the benefits of these distortions. The purchaser of a portfolio of global banking stocks
in the early 1990s is today sitting on a real loss. So who exactly is it extracting value from
these incentive distortions? The answer is twofold: shorter-term investors and bank
management.
It is not difficult to see why shorter-term investors in bank equities stand to gain from
volatility. Institutional investors in equities are typically structurally long. They gain and lose
symmetrically as returns rise and fall. Many shorter-term investors face no such restrictions.
If their timing is right, they can win on both the upswings (when long) and the downswings
(when short). For them, the road to riches is a bumpy one - and the bigger the bumps the
better. As in Merton's model, all volatility is good volatility.
Perhaps reflecting that, there is evidence of the balance of shareholding having become
increasingly short-term over recent years. Chart 8 shows the average duration of holdings of
US, UK and European bank shares. Average holding periods for US and UK banks fell from
around 3 years in 1998 to around 3 months by 2008. Banking became, quite literally,
quarterly capitalism. Today, the average bank is owned by an investor with a time-horizon
considerably less than a year.
A second piece of evidence on equity short-termism, which is specific to banks, comes from
trends in banks' capital planning. Since the late 1990s, there has been increasing focus on
return on equity (ROE) as a performance target. Indeed, major banks have recently set
explicit numerical targets for ROE as a guidepost for shareholders and managers. These
targets are revealing about investor and managerial incentives.
ROE is an entirely equity-focussed concept. As such, ROE targets p