We argue that it is crucial to consider value and structure of bankers’ pay when assessing potential threats to market integrity
The Financial Conduct Authority is currently undertaking a review of competition in the wholesale banking sector – the High Pay Centre submitted the following argument to the review:
The High Pay Centre is an independent non-party think tank established to monitor pay at the top of the income distribution and set out a road map towards better business and economic success. The financial services sector has clearly taken the lead in recent years in pushing up top pay levels, which many other sectors have emulated.
We are concerned that high levels of remuneration in parts of the financial services sector reflect market failures that allow excessive profits to be generated. We believe it is helpful to distinguish between wealth creation and wealth extraction. What we need is a financial services sector that helps its clients generate wealth in the economy at large, and earns appropriate rewards for so doing. What we have, however, is a sector that has become increasingly adept at extracting wealth from its clients through mis-selling, market manipulation and proprietary trading, and more generally through innovations that benefit the innovators more than their clients. Competition is often ineffective in putting downward pressure on charges in key markets. Incentive structures within businesses reward opportunistic behaviour that is detrimental to clients.
There is evidence of market failure in both retail and wholesale markets. We have seen a succession of mis-selling scandals in retail markets, culminating in Payment Protection Insurance where over £15bn has been refunded to consumers so far. Remuneration structures, which incentivise sales regardless of suitability, lie at the heart of this sorry tale.
In wholesale markets, there is substantially less transparency, but current investigations into interest rate-related misconduct suggest that remuneration also incentivises behaviour that is both detrimental to consumers and breaches market integrity. The failures of many innovative, complex fixed-interest products during the 2007-08 financial crisis likewise points to behaviour that was detrimental to consumers through the failure of market mechanisms to foster informed judgements of the balance between risk and reward.
We welcome the FCA’s intention to examine competition in wholesale markets. Efficient markets meet the full range of needs of consumers at minimum cost. Inefficient markets allow economic rents to be generated and extracted, to the detriment of consumers, who experience higher transaction costs. We offer no particular insights that would point to wholesale market sectors which should be given priority. In this regard, we imagine that the FCA has considerable insight from its supervision of authorised firms.
We would welcome analysis and publication of the fundamentals of the various elements of wholesale provision of financial services, quantifying the costs incurred and returns on capital earned. Models for such quantitative analysis include the past approach of the Competition Commission, for instance its analysis of PPI, and the analysis of Platforms carried out by Deloitte for the FSA in 2012, as part of the Retail Distribution Review.
The review would need to address the general aspects of market structure and conduct that lead to market failure. These include complexity, opacity, myopia, oligopoly, asymmetry of information, conflict of interest, and problems of agent/principal relationships. Particular attention needs to be paid to remuneration structures which incentivise opportunistic behaviour and allow exploitation of market failure and inefficiency for personal gain.
The outcome of the Retail Distribution Review has put the relationship between independent financial advisors and their clients on a basis that ensures transparency and aligns the rewards for successful management of funds. This approach should be extended to wholesale markets. Authorised firms should be required to agree the basis for remuneration for services with their clients and should be obliged to avoid making gains from activities that conflict with the interests of their clients.
Excessive leverage is now well recognised as a source of instability in the financial services sector, and capital requirements have been increased accordingly. What has not yet been adequately addressed is how remuneration structures, at all levels, can incentivise behaviour that is both detrimental to clients and destabilising, through the sale of inappropriate and unsuitable products.
As to the way forward, a sector-by-sector approach would be desirable, each subject to an in-depth study. But in addition, a broad overview would be needed, to identify common themes and identify new principles for conduct in wholesale markets.
The primary focus of the FCA review will be on competition in wholesale markets. Measures to promote competition would be an important part of the outcome. Some sectors of financial services, for instance general insurance, appear to be reasonably competitive and provide a good service to their customers. But in other areas, adequate competition may be harder to achieve for structural reasons. In such circumstances, other measures would need to be considered to mitigate consumer detriment, in particular to regulate the conduct of authorised businesses. In this context, it would be important to tackle the problem of remuneration structures that incentivise the exploitation of market failure.