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June 24, 2009

Cutting banks to size

In an article for the Economic Times, Arun Duggal, the former Indian CEO of Bank of America and a board member of several Indian financial services companies, has a set of drastic recommendations for disciplining global banks to ensure that they don't trigger another financial crisis of this magnitude.
One, the size of the banks should be restricted, so that some of them do not become so big as to endanger the entire financial system. Their activities should be restricted too. They should not be allowed in the investment banking or securities business.

...Six, the whole system of creation and distribution of structured products needs overhaul. Banks should be asked to keep at least half of the assets created by them on their books so that the bank managements are well aware of the risks they are accumulating and distributing.

Similarly the rating agency system needs major correction. Perhaps they should have their skin in the game and not only earn fees and then wash their hands off. Let them also keep 10% of the paper they rate on their books until it matures. It will concentrate their minds to understand and evaluate long-term risks appropriately.

Seven, and perhaps the most important, the compensation of bankers and the risk management in banks require a thorough revision. Bankers’ compensation must come down and be in line with what other professionals earn. The bonuses should be downsized and linked to various performance parameters. Private equity offers a good model of long-term incentives: they make money (carry) only if and after their investors have made money. The risk management systems in the banks should be strengthened. While this should be the primarily job of board of directors of banks, the regulators should monitor compensation practices in banks.

Arun Natarajan is the Founder & CEO of Venture Intelligence, the leading provider of data and analysis on private equity, venture capital and M&A deals in India. View free samples of Venture Intelligence newsletters and reports. Email the author at arun@ventureintelligence.in