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 / Spring 2010 / Issue 58(originally published by Booz & Company)


A Better Way to Fix Bankers’ Pay

Instead of bashing bonuses, let’s put in place the incentives we need: linking compensation to risk and capital.

Editor’s Note: This article was updated in June 2010.

The world’s finance ministers, central bankers, and regulators are currently designing a new set of regulations to prevent banks from bringing the world’s economy to its knees again. Nevertheless, the most critical question remains unanswered: Why did the system go out of control in the first place? Most bankers understood that they might face catastrophic institutional failure and enormous loss of personal wealth. Why wasn’t that enough to keep them from taking such unprecedented risks?

The implicit response seems to be that they were distracted by their greed. According to this view, these villains exploited the financial system for their own gargantuan end-of-year bonuses, got bailed out, and have every reason to do it again. Given this inherent moral hazard, it’s no wonder that so many political leaders in the United States, Europe, and elsewhere are eager to rein in bankers’ compensation.

The moral hazard is a real concern. But the plans to limit compensation will not work, because they do not address the core problem: the disconnect among bank capital, risks (borne by both banks and society), and compensation structures (particularly the way traders are paid). If the financial leadership of the Group of 20 (G-20) can follow a “triangle principle” — building a tight regulatory connection among those three factors, making them interdependent at a granular level — they will get closer to mitigating the moral hazard. And they won’t have to regulate bonuses directly.

That would be a relief. The proposals being discussed by the G-20 are aggregate, top-down proposals that could make many of the current problems worse, not better. They basically come in three flavors. The first is setting caps on the size of bonuses: for example, capping bonuses as a percentage of base compensation or limiting each bank’s overall bonus pool. If legislated (and found constitutional), this would force regulators to make Solomonic judgments about bonus sizes and bank worthiness without the information contained in market signals. And it would motivate good people to move to other sectors or less-regulated entities, such as hedge funds. As George Soros suggests, this may be a good thing, but I doubt it is the intent of the proponents.

We know that the second proposal, deferring bonuses to discourage short-term speculative risk taking, won’t work because it did not work before. Almost all the big banks’ management teams had their compensation tied to long-term stock performance in 2008. Yet the financial crisis still came. Moreover, deferral will not stop traders from changing jobs; the risk then stays with the original institution while the hiring bank pays the trader the deferral value.

The third proposal, instituting clawbacks (demanding that part of a bonus be returned after the fact in cases of failure), seems attractive, especially to the punitive-minded. But enforcement would be fraught with legal and ethical issues, as the U.S. Congress learned when it tried to retroactively tax bonuses from banks that took bailout funds.

A more general problem illustrated by this discussion on bonuses is the emerging policy preference for disconnected, across-the-board rules on capital, leverage, liquidity, and compensation. For example, one proposal would set in place a maximum leverage ratio: Borrowed funds should not exceed some value, such as 25 times equity. In principle, limiting leverage seems like a good idea, but no aggregate rule can possibly apply to the wide variety of banks, trades, and risk profiles. Such a rule would trump good judgment by skilled risk takers. And US$1 billion worth of investment capital, operating within a regulatory leverage cap, could still be deployed and lost in a million lousy trades.

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