Ethics and Finance—Aligning Financial Incentives with Societal Objectives, Speech by Christine Lagarde, Managing Director of the IMF, delivered at the Event hosted by the Institute for New Economic Thinking: Finance and Society

IMF News, May 6, 2015

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Canonical URL: Ethics and Finance—Aligning Financial Incentives with Societal Objectives, Speech by Christine Lagarde, Managing Director of the IMF, delivered at the Event hosted by the Institute for New Economic Thinking: Finance and Society

Delivered May 6, 2015, at a "Conversation with Janet Yellen, Chair of the Board of Governors of the Federal Reserve System" in Washington D.C.
Core objective: induce a change in the "culture" of the financial sector to better align financial incentives with societal objectives.
Focus areas stated:
- (i) The role of regulation and how remuneration and governance structures can help realign incentives in the financial system;
- (ii) How to induce positive change in corporate culture;
- (iii) How good regulation can be consistent with financial deepening, inclusion, and stability.
Context: Despite progress since the crisis, financial stability risks are "rising and rotating—from banks to non-banks, from sovereign and bank solvency to market liquidity, and from advanced countries to emerging countries." (Global Financial Stability Report)

Findings and analysis:

Regulatory frameworks still face challenges present six years on from the crisis: rules not tight enough, oversight not strong enough, and compensation cultures based on short-term gains.
IMF work (October 2014 GFSR) shows compensation and governance structures can reduce risk-taking and realign incentives.

Key statistics and evidence:

Sample analysis covering more than 800 banks from 72 countries.
Shareholders’ “say on pay” adoption: in 2005, only 10 percent of banks allowed shareholders to cast a non-binding vote on management compensation; today, 80 percent of banks have instituted this policy.

Policy recommendations and mechanisms:

Compensation reforms:
- Structure packages to favor long-term performance and soundness.
- Use cancellation and claw-back provisions in cases of misconduct, performance downturn, or where the institution requires direct taxpayer support.
- Strengthen shareholder voice in executive compensation decisions.
Governance reforms:
- Establish clearer separation between management and boards.
- Increase board independence—banks with more independent board members take fewer risks.
- Require rigorous "fit and proper" criteria to ensure qualification and skills of board members and key technical professionals.
Note: Recent Securities and Exchange Commission steps are encouraging in making it easier for shareholders to determine alignment between executive compensation and firm performance.

Findings and analysis:

Regulation alone is insufficient; ethical behavior must be internalized—move from rules-based to values-based behavior.
Individual accountability and the "tone at the top" are critical to fostering ethical corporate governance.
Virtues and ethical habits build over time (Aristotelian tradition).

Policy recommendations and cultural levers:

Promote individual integrity and accountability; reward ethical behavior and do not tolerate lapses in integrity.
Set a strong tone at the top of institutions.
Increase diversity in leadership:
- Evidence indicates female leadership is more inclusive.
- Rhetorical question posed: “What would have happened if Lehman Brothers had been Lehman Sisters?”
Encourage shareholders and bondholders, as well as institutions, to drive better alignment of risks and incentives.
Apply these reforms in both advanced and emerging economies—emerging economies can learn from advanced-economy pitfalls.

Findings and analysis:

IMF study (Sahay et al, 2015) reexamines financial deepening for emerging markets.
Key finding: gains for growth and stability from financial deepening remain large for most emerging markets, but there are limits on size and speed—rapid sector growth can outpace supervisory capacity and increase instability.
Regulatory reforms can increase benefits from financial development while reducing risks; reforms need not curtail credit or financial development if well designed.

Key statistics on financial inclusion and gender gap:

Globally, 2 billion adults remain without a bank account.
This represents a 20 percent drop in the number of “unbanked” over the last three years.
United States: some 8 percent of U.S. households are “unbanked” and some 20 percent are “underbanked”.
Gender gap in access to basic financial services:
- Globally, 42 percent of women lack access to basic financial services, compared to 35 percent for men.
- In a world-wide sample of banks, less than 20 percent of board members are women, and only 3 percent of bank CEOs are women.
IMF forthcoming analysis: financial inclusion is particularly important for women and, if supported by good regulation and supervision, can go hand in hand with financial stability.

Policy implications:

Promote financial inclusion while strengthening regulation and supervision to avoid excessive financial risk taking.
Use regulatory reforms to enable financial deepening that supports stability and development.
Prioritize gender-inclusive policies to close access gaps and promote diverse leadership in financial institutions.

The financial crisis exposed fault lines; lessons point to the need for collaborative effort across supervisors, regulators, institutions, shareholders, and bondholders.
Building sustainable and inclusive growth requires:
- Managing risks through strong supervision and regulation;
- Building resilience in all countries; and
- Realigning corporate culture with societal objectives.
Final admonition: there is "really no going back"—continued vigilance and reform are necessary.

Remarks by Christine Lagarde, Managing Director, International Monetary Fund, May 6, 2015.