Ong’s law of finance
When leading financial practitioners and academics convened in Qatar earlier in the autumn at the launch of QFinance to discuss the future of financial services regulation, it seemed that the economic tsunami of 2008 was finally receding and normality was returning. Banks have spent most of the year rebuilding their balance sheets and tier-one capital, and have been doing quite nicely as equity markets have surged ahead. What no-one knows is whether the world is set for a sustained v-shaped recovery, a slow and faltering u-shaped one, or a w-shaped lurch.
Equal uncertainty prevails when it comes to regulatory initiatives, and earlier determination to reform the financial sector has also faltered as various initiatives have dissipated. The EU's determination to regulate hedge funds and private equity has come under fire from the industry, which claims the proposals are an attempt to shoot the wrong guys. A lot of political rhetoric has focused on easy targets, like executive remuneration, rather than getting to the root causes, like risky securitisation and re-securitisation. The whole picture is muddied by the fact that few politicians understand the underlying issues and are prone to strike out on a limb according to short-term political pressures.
In the view of one banking risk specialist, Professor Michael Ong of the Illinois Institute of Technology's Stuart School of Business, the pressure has been to legislate on outcomes, rather than on the source of the problems. On the issue of remuneration he is clear. "It's about how the incentives are created in principle that is linked to the risk taking. If someone is paid $125m, does that mean that this person will be more or less risk-averse? In fact, there have been academic studies that show that there is no correlation. I think the process is wrong - the press has picked up on this fundamentally due to jealously."
A writer on credit risk and ratings and former chief risk officer for ABN AMRO, Ong argues that remuneration should be paid in stocks and cash, and over two to three years instead of one, over which time it can be clawed back, or even involve a penalty. "In my former bank, ABN AMRO, we actually compensated people like this," he says.
So far so good, but what about implementation? Here the answers are less clear-cut, since it is difficult first to legislate on remuneration in a free society, and in a world in which people are mobile and banks can shift operations to other domiciles to get around cumbersome regulations. Ong believes that cultures must change within institutions, and that change must come from the top. "It's clear regulation doesn't do much," he says. "It doesn't curb certain types of behaviour, nor encourage so-called good behaviour. But this does not mean that banks can be completely fancy-free and without any constraints."
He continues: "In previous speeches I advocated that we develop a black list that we will agree not to hire certain people that have screwed up big time. That would be a solution but I don't think it's legally enforceable."
One model, Ong suggests, would be a clear delineation between entities deemed to be essential to the financial system (he tries to avoid the term ‘too big to fail'), and others - shadow entities such as hedge funds or boutique investment banks that might operate as a "bank-casino". Ong says: "The ability to revert back to the norm and to generate huge amounts of so-called profits will inevitably be significantly curtailed if we have this kind of banking model."
And what about the role of institutional shareholders? At the beginning of this decade, Ong notes, shareholders forced through change in banks following the collapse of Enron and WorldCom. "The crisis is approaching the three-year mark and I haven't seen any shareholders revolt," Ong says. "Maybe many of these funds have lost money and they are shell-shocked and they did not have enough time to react immediately. I think that once the numbers become clear, I would really encourage a shareholders' revolt because that was very effective."
How would Ong distil his beliefs into one sentence? "It would be that crises are inevitable, and ‘Ong's Law' has two parts. The time to the next crisis will be shorter now than the distance in time from the previous crisis. The follow-up corollary is that the next crisis will see a loss much bigger than the previous one."