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


A Better Way to Fix Bankers’ Pay

Instead, banks and regulators would do well to link compensation, risk, and capital at a micro level. The place to start is at the source: the trading desk. Most enormous bonuses have gone to one small subset of bankers — traders. In simplified terms, they are paid as much as 50 percent of the net present value of their position each year, even though the results are played out over time. When traders win big, both they and the bank prosper. But when traders lose, they still get the reward, and the bank — and recently the taxpayers — takes the punishment, particularly when the bank has reserved insufficient capital to protect against this eventuality. There is thus an ill fit between the interests of the traders and those of the bank’s shareholders (including the taxpayers for bailed-out institutions). If a bank tries to rein in its star traders, they have likely made so much money in the past that they can simply walk away without concern.

Although my primary purpose in this article is not to address the level of compensation, this is as an obvious issue for boards to consider. A 40 or 50 percent share of profits to traders (at the expense of shareholders and capital buffers to protect taxpayers) is at least worthy of discussion, particularly when those profits depend so crucially on the institutions’ capital, infrastructure, customers, and brand, and the state’s role as underwriter of last resort. The current system strikes me as inequitable, especially over the business cycle and in light of the implied guarantees from taxpayers of support for institutions in crisis. This system also reinforces money — not values, strategy, culture, or the quality of the institution — as the only reason to work at a bank.

Competitive pressures to retain star traders, especially against hedge funds — and, yes, against inertia by boards and managements in the face of the “war for talent” argument — have entrenched this system. But the system is ripe for change. The solution lies not in aggregate, rules-based regulation, but in a microeconomic reassessment, within each bank, of how the triangle principle should be applied; that is, how to interweave the ways risk is taken, capital is allocated, and people are paid. There are probably several self-regulating and self-correcting mechanisms that banks and regulators could put in place right now. Two simplified examples of the triangle principle illustrate the point.

The first is “paying on the trade.” Instead of paying commissions based on a “mark-to-market” estimate of the value of a position, as most banks do now, base these commissions on the actual profit made when a deal is consummated and the position is liquidated. There would be no need to further reserve against the downside because the risk of the deal would be fully internalized. The second is to require each institution to reserve enough capital to account for the downside risk of the asset that has been purchased, including the value of the share of the putative profit that has been paid out in bonuses.

Either of these solutions would tie compensation and capital more directly to the risk and leverage in each contract, rather than setting up crude aggregate standards that don’t take into account the characteristics of a particular trade. Instead of shifting the burden of judgment to regulators, this approach would better harmonize individual and institutional incentives. And when bankers have reason to pay attention to the true economics of their deals, rather than to the impact on their bonuses alone, they might find themselves making better deals — and thus reclaiming the reputation they have lost.

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