I should have been more pushy in opposing risk-taking at bank


ANALYSIS:It is of profound regret to this ex-AIB director that he did not speak out more strongly during the boom, writes JIM O'LEARY

FROM 2002 to 2008 I served as a non-executive director of Allied Irish Banks. For most of my term I was a member of the board’s audit and remuneration committees. My former association with AIB places me in a difficult position when it comes to discussing what has happened in Irish banking. Many of my insights come from my experience as an AIB director, but I don’t consider myself at liberty to reveal details about decisions made by the AIB board.

I am only speaking on behalf of myself. It is not my intention to present an apologia for banks or their boards. Serious mistakes were made by banks during the boom years, the consequences of those mistakes have been horrendous, and the primary responsibility lies with banks and boards. Nothing I have to say is designed to evade that responsibility.

But I would like to address two questions. First, how can bank boards, groups of intelligent, experienced people, many of whom had earned big reputations for wisdom and sound judgment, have presided over institutions that committed such disastrous errors? Second, what changes might be made to the way banks are run in order to minimise the risk that recent experience will be repeated? The first set of remarks is a good deal more extensive than the second.

A critical impediment to be overcome in the delivery of good corporate governance outcomes is asymmetry of information. Put crudely, the starting position is that a company’s managers possess all the relevant information while the board or at least the non-executive directors have none. The board is given as much information as management is prepared to share with it.

By information, I don’t just mean raw data; I mean the wherewithal to interpret the data intelligently. Nor do I mean only the kind of information that is amenable to quantification or communication in discrete form.

The existence of the asymmetric information problem means trust is crucial, and I would suggest that, in an important sense, trust is a big part of the answer to the first of the questions set out above. Pressed to identify the overarching reason for bank boards going with the flow during the boom years, I would say it was that directors placed too much trust in management.

This is not a formula for exonerating boards. Boards of directors are ultimately responsible for running the business. The fact they delegate the task to management does not change this, but it does mean the exercise of judgment in the matter of who to trust, and to what degree, is an absolutely critical aspect of the non-executive director’s role.

Given their dependence on information flow from management, non-executive directors spend a good deal of time assessing executives’ trustworthiness. The more evidence there is that executives are open and truthful, are lucid in presentations and display a command of detail, the more they will be trusted. Clearly, there is a potential pitfall here. An open, truthful and articulate management team is not necessarily one that is running the business well. Non-executive directors need to be especially mindful of the potentially disarming effect that these admirable qualities have.

The distinction between a company doing well and a company doing sustainably well is critical. In a banking context, the link between the two dimensions of performance is risk. During the boom years, banks performed spectacularly well in terms of profits and share price growth. It is now clear, of course, that this performance was bought at the cost of greatly excessive risk-taking.

Was the scale of risk-taking such as to be reckless? Looking back from here, recklessness seems like a reasonable word, but, of course, this is hindsight bias at work.

With hindsight, it is tempting to conclude the crisis is the inevitable consequence of the credit boom. It is but a small step from this proposition to the proposition that those who drove the growth in credit did so knowing their actions would have disastrous consequences, so displaying reckless disregard for the risks they were taking.

But that is not the way the future looked at the time. The prevailing belief during the boom was that the boom would give way to the much-vaunted “soft landing”. Of course, directors understood that a much more malign scenario was possible, but they trusted the systems for monitoring and controlling risk ensured that banks would be adequately protected if such circumstances arose.

This confidence in risk systems had to do in part with the amount of time devoted to risk-related matters by banks and their boards throughout the boom. This was particularly the case at AIB. The John Rusnak debacle in 2002 had focused attention on deficiencies in the bank’s risk architecture, and ushered in a period during which extraordinary efforts were made to transform the way the bank dealt with risk – and the board’s agenda was thickly populated with risk-related items. This almost certainly conditioned non-executives to believe the general matter of risk was being well looked after.

Even among those of us who were sceptical of the “soft landing” scenario, the conviction that a collapse in house prices was likely was not strong, and certainly not strong enough to change the opinion of colleagues. Undoubtedly the sceptics could have and, with the benefit of hindsight, should have articulated their doubts more insistently. Whether this would have made much difference is something we will never know, but it is a matter of profound personal regret to me that I wasn’t more forceful in setting out the contrarian view and didn’t work harder at analysing its implications.

Reflecting the prevailing wisdom, banks made the “soft landing” their central case in designing strategy and guiding lending policies. But, mindful of the risk that something worse might occur, they carried out stress tests that purported to quantify the effects on profitability and on balance sheets of things going badly wrong. Almost without exception, these stress tests provided assurance that the banks would continue to make profits (albeit greatly diminished) and remain adequately capitalised and liquid.

We now know that these stress tests were seriously flawed. This points to gravely deficient risk measurement. It was not that Irish banks were recklessly indifferent to risk; it was more a case that they didn’t understand the risks being taken, and were not much assisted in doing so by the tools being used.

Bankers tend to be myopic and to take excessive risks during booms. These tendencies are almost certainly reinforced by competitive pressure. The day-to-day business of dealing with the threat from competitors and of defending market share is real, but disaster is an abstraction until it breaks.

This draws attention to a key purpose of boards – to protect the bank from the myopia of bankers. Evidence suggests the boards of Irish banks failed badly on this score. Too many management proposals were adopted in response to arguments that were couched primarily in terms of what competitors were doing. This line of argument should have been more vigorously challenged.

An obvious way in which the myopia of bankers can be amplified or reduced is through remuneration policy, and bank remuneration has rightly come under the spotlight. Popular commentary has concluded that personal greed was a key causal factor in the crisis. Here it is necessary to distinguish between two dimensions: remuneration levels, and the composition of remuneration packages. My own view, for what it’s worth, is that popular commentary is driven more by the former, whereas it’s the latter that matters from the point of view of incentives.

During the boom years, it was common for top bank executives in Ireland to be awarded annual remuneration packages worth several millions of euro. In the eyes of many, such amounts are scandalous and cannot be justified. The justification used by bank boards was that such pay levels were required to match the market and remain competitive, and much effort was typically spent unearthing information on market pay rates. Remuneration consultants were appointed to carry out such research. The risks of losing a key senior figure or alienating able young executives because of a parsimonious stance on pay were perceived to be too big to take.

The need to match the market can only be regarded as a proximate justification for very high pay. The ultimate justification has to be that recipients are extraordinarily valuable in terms of the rare combination of talents they bring to their posts and deploy to the benefit of shareholders. This proposition is surely one of the clearest casualties of the banking crisis.

Greed may be useful, but only up to the point where outcomes are sustainable. Vast income differentials are sustainable in a democratic society only in circumstances where a rising tide is lifting all, or at least most boats. There is a kind of social contract implicit in the acceptance of marked income inequality. If those at the top preside over outcomes that are destructive of the welfare of the general population, the terms of that contract are broken.

The comprehensive failure of the existing system of bank governance to prevent the current crisis poses some big questions. Does the existing system (unitary boards of directors elected by shareholders) need to be entirely replaced? Is the crisis to be seen as the outcome, not of institutional failure or deficiencies of organisation, but of human behaviours that will not be greatly changed, much less eradicated, by the kind of reforms that are feasible in a liberal democracy?

I pose these questions not because I intend to offer answers but because they draw attention to the possibility that the problem may not have an enduring solution. In the matter of financial crises, history repeats itself again and again and again, as attested to by Reinhart and Rogoff’s masterful historical study This Time Is Different.

On a more optimistic note, the most powerful defence against a repeat of the current crisis, at least in the medium term (by which I mean a generation or so), is the fact it has just occurred. The crisis and its consequences will live in the memory of borrowers and lenders, and will loom large in the risk models of the latter for many years. The result will be much greater risk aversion (and much more highly priced risk) than in the boom years.

This is an edited version of an address given this week by Jim O’Leary to the MacGill Summer School. A senior fellow in the department of economics at NUI Maynooth, he was previously chief economist at Davy Stockbrokers, and worked also for the National Economic and Social Council. He wrote a regular economics column for this newspaper from 2002 to 2009. The full text of his MacGill address is available at irishtimes.com

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