Bank Compensation, Governance Need Upgrade to Make Financial System Safer

Bank managers, shareholders often take too much risk, disregard cost to society

Bank creditors lack incentives to monitor risk

Banks need independent boards of directors

The IMF’s latest Global Financial Stability Report analyzes the excessive risk taking by banks that contributed to the global financial crisis, and proposes reforms to help prevent future abuses given the huge costs to society, both economic and social.

The IMF analysis provides new research into the role of governance and executive pay. This research is necessary to help shape the reforms to strengthen regulations, realign incentives, and foster stronger risk management and oversight in banks.

“Financial regulatory reform has gone a long way toward improving standards for governance and executive pay,” noted Gaston Gelos, Chief of the Global Financial Stability Division at the IMF. “But in some areas we need to go further—for example, by making executive compensation more sensitive to default risk and more dependent on longer-term outcomes. Bankers should be rewarded for creating long-term value, not for short-term bets.”

Although taking a healthy dose of risk is part of a bank’s mission, they sometimes take on more risks than is socially desirable.

Risky business

The report studies the association between risk taking, governance, and executive pay based on a large sample of banks around the world.

According to the IMF, banks with board members who are independent of bank management tend to incur less risk. Also, banks where executive compensation depends to a larger extent on long-term performance show lower levels of risk taking.

However, the level of executive compensation is not consistently associated with risk taking. Banks that have a stronger risk management function and large institutional ownership tend to take less risk, the IMF said. Banks where the CEO has a professional background in retail banking or risk management—a proxy for a more conservative risk culture—also show lower levels or risk.

Some compensation practices—such as measuring performance with gross revenue—may bias managers’ decision making toward activities with short-term gains and hidden long-term costs, or managers may choose risky investments that may compromise the bank’s solvency. This behavior may even be in interest of shareholders who prefer risky bets because their losses are limited and the potential gains are substantial.

The IMF said banks with a large amount of debt have...