Fantasy banking

Thanks to the international Financial Stability Forum, which overnight became the Financial Stability Board, we now know what the 'sub-prime-proof bank' will look like.

This ideal institution, created from the lessons of the global financial crisis, will have the confidence and support of regulators and governments in all jurisdictions.

But based on what we know about banking in the United States, Europe and Australia, it is doubtful any existing senior executive in the industry would agree to work for it.

Starting with the touchstone issue of executive remuneration, the sub-prime-proof bank will abide by standards that would be anathema to most boards of directors of banks, including those in Australia.

For example, the perfect bank would not pay golden handshakes, which are payments that reimburse unvested compensation foregone at the banker's previous employer.

Golden handshakes are commonplace in Australia in banking, insurance, funds management and in industrial companies. They have been and are still being paid by the big four banks, the major insurance groups and wealth managers. Gail Kelly got a $7 million golden handshake to join Westpac as CEO and it was partly to compensate her for benefits foregone at St George.

The Financial Stability Forum (FSF) is against golden handshakes because they are classed as compensation that is not sensitive to the time horizon of risks.

The perfect bank would not pay golden parachutes that are not sensitive to performance or risk. The FSF describes the current approach as a "heads I win, tails I still win” approach to risk.

Under the FSF guidelines the compensation incentives at banks would include a mix of cash, ordinary equity and in-the-money options, with most variable pay components deferred.

That would not suit most banks which have traditionally issued options that are out-of-the-money. The FSF says out-of-the-money options are inferior to ordinary equity in terms of risk alignment because they provide an incentive for the option holder to take too much risk to push up the share price.

In-the-money options, such as those issued by Macquarie Group, are similar to ordinary equity in that there is a payout upside when shares rise and a clawback when performance is poor.

As well as limiting the scope of options issues, the ideal bank would have its compensation policies scrutinised by the regulator and included in any assessment of the institution's soundness.

The FSF recommends that disclosure of executive compensation should extend beyond a handful of senior executives and include pay at different levels of the bank and in different units. It demands a detailed description of how compensation is related to actual performance over time.

The sub-prime-proof bank will be a boring bank to work for because of all the constraints imposed upon its capital and operations following the crazy asset growth and leverage of the past five years.

The FSF is harking back to a time that has been forgotten by most bankers. ANZ chief executive Mike Smith recently reminded his peers that banking was meant to be boring.

The FSF's ideal bank will be constructed and supervised to avoid the impact of procyclicality, which refers to the mutually reinforcing interactions between the financial and real sectors of the economy that tend to amplify business cycle fluctuations and cause or exacerbate financial instability.

The ideal bank will be built to rectify the flaws in risk management uncovered by the sub-prime meltdown and remove the distortions in incentives that left the bankers earning huge cash bonuses and the borrowers and counterparties in strife.

Structured investment vehicles will be tightly controlled so that banks can return to the key role of facilitating the supply, pricing and allocation of credit in the economy.

There will be big disincentives for shoving stuff off balance sheet. Capital requirements will rise for resecuritisation and for short term liquidity lines to conduits and or trading books.

The FSF's perfect bank will have a higher level of capital adequacy than currently exists and the quality of the core capital will be upgraded. This will required billions of dollars in additional investment by shareholders and lower the return on equity.

The ideal bank will have to abide by a leverage ratio that will prevent a repeat of the sort of thing seen in 2006 and 2007 when UBS levered up its capital by at least 30 times and, based on some measures that included off-balance sheet exposures, up to 50 times.

As well as increasing the size of the capital that has to be held against risk weighted assets, the FSF would like to see limits on the ability of traders and others within bank subsidiaries creating additional leverage through trading on margin or lending against over-the-counter securities and derivatives.

The world of banking described by the FSF has no room for the investments banks that recently joined the bankers' graveyard.

Bankers running the sub-prime-proof institution will report lower profits because they will have to use their "credit judgement” to make provisions against loans when they are written.

The banker given the task of running this invention of the world's regulators would have to get used to having supervisors constantly looking over his or her shoulder.

Regulators will be monitoring stress testing, stepping in to dampen excessive pro-cyclicality, using quantitative measures to keep leverage in check and intensifying their oversight of maturity and liquidity mismatches.

The banker running this aspirational institution will also face much higher costs of compliance. More data about risks on the balance sheet will have to be provided to regulators and to the public. As well, it is possible many key accounting rules will be changed.

If this all sounds too hard for a budding banker of the future there is always the prospect of joining a regulator. They will need the staff.