BIS central bankers’ speeches  7  Third, what tools might such agencies bring to bear in tackling financial arms races in return, speed and safety? With hindsight, it is not difficult to identify instruments which might have slowed the pre-crisis race for excessive returns in banking. The most direct and effective would have been to place tighter constraints on banks’ leverage. This would have defused the return on equity race at source. The FPC has prioritised the leverage ratio as a macro-prudential instrument in its recommendations to date.29 A complementary approach would have been to require banks to adopt performance metrics which did a better job of adjusting for risk. At the end of last year, the FPC raised concerns about the use of return on equity metrics by banks which generate incentives to shrink equity to hit return targets.30 Some institutional investors have raised similar concerns – and are showing encouraging signs of acting on those concerns. After all, it is not difficult to devise performance metrics which would do a better job of adjusting for risk, such as return on bank assets. There is some evidence recently of return on equity targets having become a less important determinant of some banks’ portfolio allocation and executive pay decisions. But equity returns remain hardwired into both to some degree. Moreover, many global banks continue to publish return on equity targets. This continuing attachment to counter-productive performance metrics is a puzzle – and a worry.

32  Haldane (2011), Mehran and Mollineaux (2012). 33  Bank of England (2012), Bank of England (2011b). BIS central bankers’ speeches  9  In finance, these tragedies of the commons are, if anything, more likely than in other fields (seas, beaches and forests). The financial crisis attests to that. If there were a benign, enlightened regulatory planner, able to redirect competitive forces, this could potentially avert future tragedies of the financial commons. Fortunately, there is. References Aikman, D, Haldane, A G and Nelson, B (2010), “Curbing the Credit Cycle”, available at http://www.bankofengland.co.uk/publications/Documents/speeches/2010/speech463.pdf. Angel J, Harris L and Spatt C (2010), “Equity Trading in the 21st Century”, Marshall School of Business working paper. Bank of England (2012), “Record of the interim Financial Policy Committee Meeting, 16 March 2012”, available at http://www.bankofengland.co.uk/publications/ Documents/records/fpc/pdf/2012/record1203.pdf. Bank of England (2011a), “Instruments of Macroprudential Policy – A Discussion Paper”, available at http://www.bankofengland.co.uk/publications/Documents/other/ financialstability/discussionpaper111220.pdf. Bank of England (2011b), “Record of the interim Financial Policy Committee Meeting, 23 November 2011”, available at http://www.bankofengland.co.uk/publications/Documents/ records/fpc/pdf/2011/record1112.pdf. Barclays Capital (2012), “Over Promising? Encumbrance at European Banks”, 8 March. Byatt, A, Fothergill, A and Holmes, M (2001), “The Blue Planet: A Natural History of the Oceans”, British Broadcasting Corporation. Bebchuk, L A and Fried, J M (2003), “Executive Compensation as an Agency Problem”, Journal of Economic Perspectives, Vol. 17(3), pages 71–92. Brunnermeier, M K and Oehmke, M (2010), “The Maturity Rat Race”, National Bureau of Economic Research, Working Paper 16607.