Banking should be boring

Changing the rules of the game may help safeguard our money. But the most important reform is bankers' characters.

Late last year, Alistair Darling, the UK’s lord of the Exchequer, introduced a one-off 50 percent tax on bonuses upwards of £25,000 (around US$40,000). This is just a prelude to a 50 percent income tax rate to be slapped on the highest earners beginning next fiscal year. City executives cried foul and threatened to leave for less oppressive fiscal climes However, both the French premier, Nicholas Sarkozy, and the German chancellor, Angela Merkel, thought it was an initiative worth emulating, and pressure has started to mount on US president Barack Obama to follow suit. Is this just or is it simply giving way to envy and vengeance in the season of good cheer?

Green shoots notwithstanding, the ghost of the recent economic crisis still looms large and heavy on most of us. The record profits on which those bankers’ bonuses are based would not have been possible without government bailouts. And even if some banks never received public money directly, nonethelesss they equally benefited from tax-payer financed liquidity. Without such guarantees, they would have gone the way of Lehman Brothers and Bear Stearns. Instead of treating themselves to obscene bonuses —half of their annual revenue or $17B for Goldman Sachs this year— bankers could use the money to shore up capital and secure their positions..

This discussion brings us back to the issue of bankers’ pay. For Harvard’s Lucian Bebchuk, there seems to be a consensus that compensation structures of financial firms incentivize excessive risk-taking, while shielding agents from losses and a substantial part of their responsibilities. Bankers’ pay focuses on short-term results and rewards them accordingly, even if outcomes are later on reversed. Likewise, though stock options may align bankers’ interests with shareholders, they still leave out the concerns of significant groups of bondholders, depositors and the government as ultimate guarantor of the bank’s stability. To avoid instances of "pay without performance", Bebchuk suggests delaying the time when options could be cashed out from when they vest and tying compensation to a broader basket of shares and bonds, aside from common stock.

For his part, Steven Kaplan, from the University of Chicago, is quite sceptical about the negative impact of bankers’ remuneration on overall economic health. He thinks, rather, that the blame lies on government regulators who implemented highly expansionary monetary policies for too long due to largely political reasons. What we should do now is to raise pro-cyclical equity capital requirements and contingent long-term debt. That means increasing equity percentage during booms and converting debt into equity during busts. In effect, it consists in "saving for a rainy day" instead of "making hay while the sun shines".

Despite their differences, Bebchuk and Kaplan coincide in their fundamental strategy. Both seek to change bankers’ behaviors exclusively by tweaking individual economic incentives. But these aren’t the only factors that affect conduct nor are they always the most important ones. Incentives aren’t physical objects and a $100 bill means different things to different people. In consequence, they react in an unpredictably different manner.

That’s why none of the measures that Bebchuk and Kaplan recommend are foolproof. At most, they could only be followed prudentially. Setting a later date for cashing out options from when they vest or linking pay to more indicators than the price of common shares may make sense, but it’s not the government’s role to decide when or which other indicators to consider. Similarly, increasing procyclical equity capital requirements and contingent long-term debt may be healthy, but the exact percentage is again a moving target, even for government. Overshoot it and you prevent banks from lending money, which is what they should be doing in the first place. This also explains why the evidence thus cited on the relation between a variety of pay packages and corresponding employee performances is far from conclusive. In a given year, a bank executive could forego all salary and bonus, yet still give it his very best.

As for the much bandied around danger of a brain-drain in the banking sector or a stampede from certain jurisdictions once higher taxes come in place, I seriously doubt that any of this would happen. More things should tie a person to work in a firm or a city besides money. Otherwise, it would be best to let him go.

Banking is essentially taking care of other people’s money and as such is invariably discreet and boring. It’s not "doing God’s work" as Lloyd Blankfein of Goldman Sachs infamously alleged, but a job where reckless thrill-seekers and risk-takers need not apply. Neither should we buy into the claim that technology and globalization have magically transformed bankers’ productivity to justify stratospheric incomes. Money doesn’t grow simply because it changes hands faster, but because it is carefully invested. If ever, increased connectedness has also made all of us even more vulnerable.

Perhaps dwelling too much on the rules and the moves of bankers’ pay as if it were a chess game distracts us from an even more important area of reform: to begin with, choosing the right people with whom to entrust our money. And that is a question of character more than anything else.

References:

Lucian A. Bebchuk, "Fixing Bankers’ Pay", The Economists’ Voice (www.bepress.com/ev), November 2009.

Steven N. Kaplan, "Should Banker Pay Be Regulated", The Economists’ Voice (www.bepress.com/ev), December 2009.

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