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(originally published by Booz & Company)


Solving Moral Hazard in Banking

On the first aspect, an immediate improvement would be to pay on realized cash profits (on the P&L). A trader would be paid on the net position as it unwinds year after year rather than on the accounting net present value (NPV). On the second aspect, an obvious improvement would be to use risk-weighted assets, rather than assets alone, as the unit of analysis. None of this would prevent a trader from maintaining a shadow account over the long term in the form of a “personal balance sheet,” preferably including his or her own capital in the mix. And if the institution were unwilling to align the tenor and two-way symmetry of compensation contracts with traders, the regulator could compel it to hold more capital for situations in which a greater share of the NPV of riskier positions is paid out in compensation.

The other important set of issues has to do with the level of compensation and the share of profits going to traders; both have risen dramatically in the last two decades. The outrage over the level of compensation paid to traders is largely misplaced. Nevertheless, the questions stirring in public debate are important and in the long run dangerous for banks. Trading has increasingly come to be characterized as a skill business, not unlike Formula One driving or championship tennis. But there is at least some truth to the notion that the trading business is dependent on central bank policies and the capacity for technology to present infinitesimal arbitrage opportunities across the world — which, when aggregated over very large leveraged balance sheets, create massive profits that individuals, certainly, and even lesser institutions cannot duplicate. A growing undercurrent suggests that in fact these are not terribly useful economic activities, and thus can be taxed, with complete justification, at onerous rates. The counterargument — that taxation will depress shareholder returns and curtail lending — is true only if the share of profits paid as compensation remains constant.

This seems an obvious issue for boards to consider. A 40 or 50 percent share of profits to traders at the expense of shareholders — and the capital buffers needed to protect taxpayers — must be worth discussing, particularly when those profits depend so crucially on both the institutions’ capital, infrastructure, customers, and brand, and the state’s role as underwriter of last resort. The current system appears inequitable, especially over the business cycle and in light of the unfunded guarantees from the state. Parenthetically, 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 when hedge funds are bidding for their services, and inertia by boards and managements in the face of the war-for-talent argument have entrenched this system. It is ripe for change. And although the government tax proposals at hand may have a soothing effect on outraged citizens and may enrich the Treasury, they will have no effect on curbing bonuses, or preventing the next systemic crisis, unless there is global coordination of the response. Real change will come only when both boards and regulators realize that they have an identical goal — ensuring institutional longevity to ensure systemic stability — and that reform is therefore in everybody’s interest.

Author Profile:

  • Shumeet Banerji is chief executive officer of Booz & Company.
  • Editor’s Note: This article is updated from an earlier piece that appeared in the Spring 2010 issue of s+b.
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