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Thursday, January 31, 2008

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A Tasmanian Heritage

Perhaps it's my Tasmanian heritage but I have a natural suspicion of the idea that in matters of government one size fits all. Hence I have reservations about the commitment of the Rudd Labor Government to force through its plans for a national education curriculum.

The Prime Minister was yesterday extolling the virtues of his plan. He promised that his National Curriculum Board will draw together the best programs from each state and territory into a single curriculum to ensure every child has access to the highest quality learning programs to lift achievement and drive up school retention rates. The task of deciding what are the best programs is being given to Professor Barry McGaw who is currently the Director of the University of Melbourne's new Melbourne Educational Research Institute, and formerly Director of Education in the Organisation for Economic Co-operation and Development based in Paris.

That all sounds reasonable enough but in the future, after all subjects are the same nation wide, there will be no comparisons to make between different systems. Innovation will become a risky business with the potential for all Australian students to be lumbered with mistaken educational theory.

That Dirty Word Regulation

Regulation is the dirty word that Treasurer Wayne Swan will need to get used to as the world-wide consensus grows that more controls are needed on the free-market ways of banks and other financial institutions. The Wall Street Journal reports that leaders of Europe 's four largest economies have agreed to push for a tougher, more-global way of regulating the world's markets and banks. Led by British Prime Minister Gordon Brown, the leaders are banking that, by joining together, they will be able to convince the U.S. and others to sign up. The Journal says the Europeans plan to use their agreement reached yesterday on a list of principles and objectives to strong-arm banks to promptly disclose their full losses and credit-ratings agencies to provide better explanations of complex securities.

Perhaps our Treasurer could start the ball rolling by taking note of comments last year by the head of the Australian Prudential Regulation Authority John Laker about the way bank executives are paid and introduce a new regulation or two.

An obvious area of potential agency risk after sustained good economic times is executive compensation. In the Australian banking system, executive compensation arrangements in listed institutions tend to involve a fixed annual salary and share options conditional upon performance. Typically, the option grant is zero if performance, often defined as total shareholder return relative to a benchmark group, is in the bottom half of the benchmark group; from the 50th to the 75th percentile of performance, the grant increases and a cap typically applies around the 75th percentile. The performance period is often five years.

Executive compensation that helps to deliver strong risk-adjusted returns on capital over time and rewards genuine out-performance of competitors does not raise prudential issues of itself. For a prudential regulator, agency risk issues arise if compensation arrangements encourage management to focus on a shorter term horizon than the long-term approach that would also be in depositors' best interests. Incentives to drive up the share price more rapidly than competitors can tempt management to pursue aggressive growth strategies or to ‘hollow out' the institution by paring back capital buffers or cutting costs, particularly in middle and back offices where risk management functions reside.

As a prudential regulator, APRA does not involve itself in the details of executive compensation arrangements. These are matters for boards and shareholders. Nonetheless, growth strategies, the size of capital buffers and the resourcing of risk management areas are major elements of APRA's supervision of banking institutions and form crucial inputs into its risk-rating system.

Concentrating the Mind

To help you concentrate your mind on this question of credit ratings and their importance, consider this comment overnight by Oppenheimer analyst Meredith Whitney about banks maybe having to write down up to $US70bn if bond insurers lose their AAA credit ratings, with losses concentrated at Citigroup , Merrill Lynch and UBS: “This is significant, as many investors are of the belief that the fourth quarter was a ‘kitchen sink' for all outstanding capital hits this credit cycle. When it becomes clear [as we think it will] that more charges are on the horizon, we believe the market will take another turn for the worse.” $70bn. $70,000,000,000 doesn't sound much if you say it quickly, just a humble 27% or so of Australia 's total gross domestic product.