ANDREW Haldane, the executive director for financial stability of the Bank of England, has given many excellent speeches but his latest effort is a must-read for anyone who wants to know how we got into this current financial mess.

The speech deals with "the flaw" that so confounded Alan Greenspan, how private sector investors failed to control risks in the banking sector. The problem was not that bank executives had no skin in the game; in 2006, the managers with the largest bank stakes were Dick Fuld of Lehman Brothers, Jimmy Cayne at Bear Stearns, Stan O'Neal at Merrill Lynch, John Mack at Morgan Stanley and Angelo Mozilo at Countywide. All lost substantial chunks of their wealth as share prices collapsed.

The fundamental problem is that tax rules (the deductibility of interest) and regulations encouraged banks to gear up their balance sheets. Effective control of the banks, however, rested with the shareholders. As Haldane puts it

Ownership and control rights are vested in agents comprising less than 5% of the balance sheet.

Thanks to limited liability, the losses of these shareholders are also constrained. In the early 19th century, liability was unlimited, prompting banks to run with much more conservative balance sheets. But that was deemed to deprive industry of much-needed capital so limited liability was brought in.

That transferred the responsibility for monitoring bank managers from shareholders to depositors. Haldane points out that, in the 19th century

Depositor flight and bank runs came thick and fast, operating as an effective disciplining device on managers and shareholders

The Great Depression illustrated the economic damage that could be caused by widespread bank runs, so deposit insurance was brought in. With the liability of shareholders and depositors now limited, the disciplinary role fell on the holders of debt. But they proved hopeless in the task. In the run-up to the crisis, Haldane points out that

Credit default swap premia for all banks fell dramatically between 2002 and 2007, on average by around three-quarters. Market perceptions of risk were falling at precisely the time risk in the system was building.

The problem seems to be that while, in theory, creditors would bear the pain if banks collapsed, in practice creditors doubted that they would.

Having debtors assume pain on paper is fine in practice. But crisis wars are not fought on paper. And if debtors recognise that risks in contracts will not be enforced, they will no longer have incentives to price risk and exercise discipline themselves. So it has been for well over a century.

So that left bank executives to their own devices. As is well known, they were incentivised by share options, a process that in theory aligned their interests with equityholders. Again, this did not work well in practice. Those investors who bought bank shares in the early 1990s have lost money in real terms. But investors are not long-term holders any more. The average holding period for US and UK bank shares fell from 3 years in 1998 to around three months by 2008.

Those short-term investors were hoping to ride the ups and downs of the market, and thus welcome volatility. They thus allowed a system to develop where bank executives used return on equity as their target measure. The easiest way to increase return on equity is to take on more debt; you have more capital to pursue profitable opportunities for the same amount of equity.

That brings in the killer statistics of Haldane's speech.

Imagine that in 1990 bank CEO pay had been indexed to bank ROE. By 2007, CEO compensation would have reached $26 million. That is precisely in line with their actual payouts. If you believed ROE were a reliable performance metric, US bank CEOs would have had a watertight defence back in 2007.

Instead, of course, we had ludicrously leveraged banks that were too big to fail and brought the economy down with them.

But there is an alternative measure, return on assets (ROA), which allows for both debt and equity. As Haldane notes

Imagine if the CEOs of the seven largest US banks had in 1989 agreed to index their salaries not to ROE, but to ROA. By 2007, their compensation would not have grown tenfold. Instead, it would have risen from $2.8 million to $3.4 million. Rather than rising to 500 times median household income, it would have fallen to around 68 times.

In other words, if we had used the right risk measure, the worst of the recent mess might have been avoided, and bankers would not have grown so obscenely rich.

On that note, I am off to New York for the Buttonwood conference. Hope to report back on Friday.