Voice of Future Generations

Eliminating Perverse IncentivesHow to build Future Finance

Stefan Biskamp, Schifflange, April 23 2009

Contents

1. The World Future Council Future Finance Commission

2. Future Finance – Vision and Obstacles

3. Eliminating perverse Incentives

4. Bank Bail-Outs as perverse Incentives

5. Intermezzo

6. Corporate Charter Reform

7. Complementary Currencies

8. Negative legal enforcement to curb Speculation

9. Improving Risk Assessment

10. Natural Capital Depletion Tax

1. The World Future Council Future Finance Commission

What is a WFC Expert Commission?

• An Expert Commission is the decision-making body for WFC programmes or projects. The group is composed of a Chair drawn from the Council, a staff coordinator, a Member of the Board of Directors and members from the Council, Board of Advisors and staff.

• Academics, researchers, civil society, business persons and Members of Parliament will also be appointed as necessary.

• On the basis of the WFC’s mission to be a voice of future generations, the Commissions identify best policies that will help create a more just, sustainable and peaceful world.

1. The World Future Council Future Finance Commission

The Future Finance Commission:

• Launch of the Commission: March 27th – 30th at Sekem, Egypt. Host: Councillor Ibrahim Abouleish.

• Members include Councillors Maude Barlow, Riane Eisler, Olivier Giscard d´Estaing, Prabhu Guptara, Frances Moore-Lappé and Francisco Whitaker, member of the Board of Advisors Margrit Kennedy, and WFC founder Jakob von Uexküll.

• Identification of concrete policy proposals; media coverage in the context of the G20 process.

• Further projects: At least three best-policy brochures promoting core policies. Preparation of parliamentary hearings especially on reform of corporate charter legislation.

2. Future Finance – Vision and Obstacles

Our Vision:

Future Finance …

… supports real wealth creating developments,

... makes money our servant not master,

… helps to combat poverty and climate change,

… builds trust and fosters accountability,

… brakes growth imperative and short-termism.

2. Future Finance – Vision and Obstacles

The Obstacles:Current Finance …

… dominates real economy,

… serves to make money out of money,

… increases poverty and climate change,

… creates growth imperative and short-termism,

… deteriorates trust,

… destroys accountability.

3. Eliminating perverse incentives

Why is it important to eliminate perverse incentives?

• If basic incentives are wrong no government control will help. Regulation cannot break the innovative power of the financial industry. Regulatory loop holes have to be closed, but thanks to their innovative power the players will always find ways to circumvent regulation.

• It is a myth that the financial industry is not regulated. In the current crisis strongly regulated banks caused danger – not poorly regulated hedge funds.

• Therefore the policy proposals focus on eliminating perverse incentives instead of creating new bureaucracies controlling and supervising the financial industry.

• Proposals are designed to have maximum impact and transformation lever.

4. Bank Bail-Outs as Perverse Incentives

Problem: Since Lehmann Brothers went bankrupt all major banks in trouble were bailed out – a serious perverse incentive for bank management to try it again later.

Two basic arguments in favour of bank bail-outs:

Argument 1: Risk of contagion

But: No public disclosure of information on this risk

Argument 2: Risk of a credit crunch. A bankruptcy would deteriorate trust.

But: Empirical data show that in many countries there is no lack of loans.

4. Bank Bail-Outs as perverse Incentives

Example Germany: Loans to enterprises are increasing

Public

Commercial

Mutual

Bankenverband, January 2009

4. Bank Bail-Outs as perverse Incentives

Example Europe:

Q3 2007:

Lending conditions of European banks (l.) were tightened and, at the same time, credit demand (r.) went down.

Q3 2008:

Bankruptcy of Lehmann Brothers has significant but minor effect.

ECB Bank Lending Survey, January 2009

4. Bank Bail-Outs as perverse Incentives

• Solution 1: Detailed information on troubled financial institutions has to be provided to the public if a bail out is considered. Public hearings to decide whether a bail out is justified.

• Solution 2: If bail out is approved the bank should be taken into state ownership to minimize costs for the taxpayers. Civil society, business and parliaments should have majority representation in supervising financial sector assets taken over by the taxpayers.

4. Bank Bail-Outs as perverse Incentives

Solution 3: Banks too big to fail should be split up. Having defined the maximum size of a bank (in terms of total assets vs. GDP) no bail-out for systemic reasons will be necessary anymore. Bigger banks should have higher solvency ratios.

Remark: In addition, smaller banks should be freed from unnecessary regulatory burden. In turn they should disclose information on their lending and refinancing business.

5. Intermezzo

If the credit crunch argument is questionable – why did the financial crisis infect real economy at all?

Answer: Major parts of global economy were brittle already before the crisis. Growth imperative and short-termism stretched the balance sheets and caused increasing volatility – leading to a …

… resonance catastrophe:On November 7th 1940 the Tacoma Narrows Bridge collapsed. The bridge was built too slim and unstable. Wind hit the resonance frequency of the bridge. Since vibrations were not controlled (properly regulated), the center span of the bridge collapsed.

5. Intermezzo

5. Intermezzo

5. Intermezzo

5. Intermezzo

5. Intermezzo

6. Corporate Charter Reform

Problem: Shareholders are not accountable for social and environmental damages caused by their corporation.

Solution 1: Corporate charter legislation should mandate responsibilities, in return for limited liability privileges. Corporations should be forced to account for the environmental damage they cause => new accounting standards defining the responsibilities of corporations.

6. Corporate Charter Reform

Example: Operational boundary of Nike will include not only 30,000 employees but 800,000 workers in contracted factories. The fraction of workers employed under ILO standards can be measured.

Solution 2: There is a simple way to create positive incentives for shareholders:

If a bank provides credit or equity to firms with high ecological and social ratings

=> Shareholders of the bank pay less capital gains tax.

=> huge transformation lever.

6. Corporate Charter Reform

Remark: Defining the true operational boundaries and their responsibilities is difficult – but can be done. Rating corporations according to their newly defined duties is difficult too – but is possible => total social and ecological footprint of a corporation.

Solution 3: Banks and firms with high ecological and social ratings provide a major fraction of their return on equity in non financial terms as common good. They should be compensated. Possible measures:

• Tax relief• State guarantees for “good banks”

6. Corporate Charter Reform

Solution 4: Salary increases for CEO’s should be reflected across the whole workforce. The gap between highest- and lowest-paid employees should be reduced to earlier ratios (e.g. 25:1) but including all “employees”, also those outsourced. => eliminates incentives for short-termism.

Remark: The global market for board members is a myth. There is no free market price fixing mechanism for CEOs.

Remark: In addition, the liability of board members and directors should be enhanced.

6. Corporate Charter Reform

Evolution of executive pay versus average employee wages

in the United States, 2003-2007

6. Corporate Charter Reform

Average Executive Pay, 2007

7. Complementary currencies

Problem 1: Monopoly currencies are very efficient, but not resilient.

Problem 2: Interest rates provide perverse incentive to make money out of money.

Solution: Complementary currencies can revive the economy => Implement a variety of low interest rate complementary currencies:

• Business-to-Business currencies• Regional currencies• Special purpose currencies (designed e.g. for

health care, or to support green industries)

8. Negative legal enforcement to curb speculation

Problem of regulating financial speculation: Bans are likely to stimulate attempts to circumvent them by inventing slightly different instruments.

Solution: Negative legal enforcement. Contractual obligations based on speculative financial products not approved by the regulatory authorities are not legally enforceable.

Example gambling: Unpaid gambling debts – seen as immoral – are not legally enforceable.

9. Improving Risk Assessment

Problem: Incentives to sell complex risky financial products.

Solution 1: Banks should be forced to provide guarantees for proper risk assessment of their products, as is well known in many other industries. If risk accounting proves to be wrong, they must take back their products.

Solution 2: Financial products should be classified according to their risk (green, yellow, red – as in food industry). Very risky products should have mandatory warnings => buying risky financial products becomes taboo over time.

9. Improving Risk Assessment

10. Natural Capital Depletion Tax

Problem: High taxes on labor and goods; barely any taxes on bads => bias against ecologically responsible action.

Solution: A Natural Capital Depletion Tax would compensate for the damage caused during a product’s production process and redirect money flows quickly.

*A Green New Deal. Joined-up policies to solve the triple crunch of the credit crisis, climate change and high oil prices, Green New Deal Group 2008

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Stefan BiskampCommission Co-ordinator Future Finance Manager

World Future CouncilBei den Mühren 70D-20457 HamburgGermany

Phone: +49 (0)40 3070 914-26 Fax: +49 (0)40 3070 914-14Mobil: +49 (0)173 928 6116Email: stefan.biskamp@worldfuturecouncil.org

Thank you for your Attention!

www.worldfuturecouncil.org

Thank You!