Much has been made of the comments made by Gordon Brown in his interview with the FT that bonuses need to be linked to long-term performance. This is true, but it is important to recognise the context in which his comments are made. Bonus culture is discussed almost as an aside; other risks are rightly discussed in greater detail and these need to be considered somewhat more urgently.
1. Boards did not understand the risks they were running. It is crucial that boards are required to have the expertise to run these complex, multi-faceted financial organisations. It is just as important that banks are required to put in place risk management processes that allow the identification, assessment of management of existing and emerging risks. This means that a greater focus on enterprise risk management is needed. This is allowed for in Basel II, the framework under which banks are managed, but regulators need to be given the resources to be able to ensure that sufficient risk management processes are in place.
2. Insufficient capital was held by banks. Basel II recognises that capital is not an alternative to good risk management; however, it is still important that banks hold enough capital to protect them in harsh financial climates.
3. Credit rating agencies did not rate complex financial instruments correctly. Given that there are far fewer complex intruments around than there used to be, this is perhaps less of an issue at the moment, but lessons from their failings must be learnt. Otherwise, reliance on flawed risk identification might contribute to some future crisis.
4. Products were too complex to be analysed. This point is made in the interview as a criticism of the products as much as those analysing them. This is, perhaps, unfair as many of the products allowed risks to be divided according to the risk appetites of a wide range of investors.
An important area that Gordon Brown does not cover in this interview is liquidity. It is important not only that banks have enough capital, but also that they can get hold of it when they need to. The Basel Committee on Banking Supervision recognised this some time ago, starting consultation in February 2008 and publishing principles in September that year.
Finally, it is worth noting that there are a range of behavioural factors that contribute to the financial crisis, not least in relation to bonuses. The size of bonuses and the their timescale have been the focus of much of the comment, but the payment of bonuses based on performance of groups rather than individuals leads to a dangerous concentration of risk within teams. There is little incentive to act differently from the crowd if strong performance will not lead to a significantly improved bonus, but poor performance will leave you out on a limb. Although bonuses are not the main issue, if they are going to be reformed all aspects of bonus structures should be considered.
