Bonusses and regulation

Introduction

Yaron Brook, author of the bestseller ‘Free Market Revolution’, started his presentation with a short introduction about the Ayn Rand Institute, of which he is the Executive Director.

The Ayn Rand Institute promotest he philosophy of Ayn Rand (1905-1982). She made her philosophy of objectivism available to a large audience in her bestselling novel Atlas Shrugged from 1957 which still sells hundreds of thousands of books each year.

The book is about the individual, property, and pursuit of happiness as the only moral basis for a true free society. This true free society must organise laissez faire capitalism. Atlas Shrugged proves a source of inspiration to many readers thanks tot he principles of objectivism brought forward in the novel. This philosophy of objectivism is a guide for life. It holds that we use reason to understand the world, and its morality is to follow ones own rational self interest and laissez faire capitalism.

Presentation

The financial sector has often been blamed as the culprit fort he worldwide financial crisis of 2008. Yaron Brook stated that the crisis wasn’t caused by bankers who became notoriously selfish overnight, causing the credit crisis by their behaviour. Bankers have always been, and will always be selfish (and that’s good, in the sense of the philosophy of objectivism).

The financial sector is the most regulated industry in the world. In The US this industry is subject to five different governmental agencies supervising and regulating the industry. The crisis of 2008 was caused not by bankers, but by government, dr. Brook explained.

The influence of central banks should be limited. Policy of the Federal Reserve Bank in the United States caused interest rates to drop, encouraging people to take on debt. Both Democratic and Republica governments stimulated people to buy their house. Artificially low interest rates were an incentive to get higher mortgages. Banks supplied these mortgages knowing they woud be bailed out if loans weren’t be repaid as they are deemed too big to fail.

Only real free, unregulated markets can serve the vital function of finance, which is transferring capital from capital suppliers to capital recipients and develop economic activity.

It takes expertise, knowledge and skills to be an excellent banker or investment manager to decide which investment opportunities to follow, and which ones not, whom to grant a loan to, which company to finance with an equity stake, and luck has got nothing to do with it.

The semi free Western world as we kno wit could not exist i fit weren’t for financiers but regulators and legislation assume bankers and the financial industry as a whole are crooks who need tob e restricted. This is unproductive damages innovation.

A bonus is granted if a special effort was made and paid better than average results. It is a private agreement between two parties. This should not be regulated. Dr. Brook said to have more faith in business men who, motivated by their rational self interest agree to a deal that is beneficia lto all parties, including if this agreement containes bonusses, than a government bureaucrat deciding on complex matters such as bonusses and remuneration policy, probably creating wrong incentives in the maret whilst doing that.

Bonus malus and outsourcing of investment management by a pension fund

As managing director of the Health and Welfare Pension Fund Peter Borgdorff explained the position of the pension fund when it comes to bonusses when outsourcing investment management activities. I fan exceptional result warrants a bonus, then a bad result warrants a malus, meaning the external investment management firm should pay back part of the management fee.

The Health and Welfare Pension Fund includes the principle of a bonus in case of outperformance and a malus for underperformance in its investment management agreements.

Legislation on bonusses and outsourcing investment management

Legally, in the Netherlands the remuneration of a pension fund board member should fit into a remuneration policy that doesn’t give an incentive to take on more risk than acceptable tot he pension fund. Pension fund boards should get more professional in terms of time board members can dedicate tot heir board membership, knowledge, particulalrly in the fields of investment management and risk management, and skills.

Dutch Central Bank interviews board members to test whether they are qualified to do the work. Along with qualified professionalism in pension fund boards comes the remuneration for board members, which might be higher than usual given the limited amount of five allowed board memberships pursuant pension fund law, and to fill board memeber vacancies with seasoned professionals.

When a pension fund outsources investment management activities the remuneration policy of the party to whom the investment management mandate is granted, should be assessed by the pension fund to see whether the policy of the third party encourages taking risk that won’t match with the risk profile of the pension fund. This means that commercial investment management firms must provide the potential pension fund client with their remuneration policy. It also means a pension fund must have the expertise to be able to assess a remuneration policy in terms of risk and behaviour. As long as a pension fund is able to do that, it can agree to carried interest, bonusses and other incentives for outperformance.

Remuneration policy, incentives and trust

Prof. dr. Jaap Koelewijn started the presentation by saying that bonusses are not bad on principle. They should give the right incentive to achieve extraordinary results. Often, however, a pension fund doesn’t know or understand which bonus leads to which incentive, which may result in paying a bonus for a result that had much less to do with skills and experience, and more with luck and general market conditions.

Particularly among alternative investments such as private equity and hedge funds it is customary that employees invest with their own money along with the fund they manage. This creates an alignment of interest between external investors such as pension funds, and the alternative investments manager.

Prof. Koelewijn stated that pension fund trustees must work hard on their knowledge and understanding of investment management. A one day course won’t cut it. They will need to educate themselves at a high level to  be able to outsource millions and millions of euros of other people’s money to specialised investment management firms.

Trust is of the essence in anyrelationship, including business deals. Thick stacks of paper containing a contract is often a sign that the business relationship isn’t working. If that’s the case, better not negotiate a deal with a party.

Regulation requiring all sorts of things from pension fund trustees will only lead to a ‘check the box’ mentality because the regulation is not aimed at specific situations or people. For example, said prof. dr. Koelewijn, as professor finance and doctor of banking supervision, he had to explain tot he supervisory Authority Financial Markets that he is knowledgable about investment management as part of the assessment as pension fund trustee. If the person who is assessed becomes the focus, and not the reguation tob e complied with, there will be less checking the box.