Why regulators should intervene in bankers' pay
By Martin Wolf
You really don't like bankers, do you?" The question, asked by a former banker I met last week, set me back. "Not at all," I replied. "Some of my best friends are bankers." While true, it was not the whole truth. I may like many bankers, but I rather dislike banks. I recognise their necessity, but fear their irresponsibility. Worse, they are irresponsible partly because they know they are necessary.
My attitude to the banking industry is not a prejudice. It is a "postjudice". My first experience with out-of-control banking was when I watched the irresponsible lending that led to the devastating developing-country debt crises of the 1980s.
The world has witnessed well over 100 significant banking crises over the past three decades. The authorities have even had to rescue important parts of the US financial system - on most counts, the world's most sophisticated - four times during the same period: from the developing country debt and "savings and loan" crises of the 1980s to the commercial property crisis of the early 1990s and now the subprime and securitised-credit crisis of 2007-08.
No industry has a comparable talent for privatising gains and socialising losses. Participants in no other industry get as self-righteously angry when public officials - particularly, central bankers - fail to come at once to their rescue when they get into (well-deserved) trouble.
Yet they are right to expect rescue. They know that as long as they make the same mistakes together - as "sound bankers" do - the official sector must ride to the rescue. Bankers are able to take the economy and so the voting public hostage. Governments have no choice but to respond.
Nor is it all that difficult to understand the incentives at work. I gave the broad answer in my column, "Why banking is an accident waiting to happen" (Financial Times, November 27 2007).
It is the nature of limited liability businesses to create conflicts of interest - between management and shareholders, between management and other employees, between the business and customers and between the business and regulators. Yet the conflicts of interest created by large financial institutions are far harder to manage than in any other industry.
That is so for three fundamental reasons: first, these are virtually the only businesses able to devastate entire economies; second, in no other industry is uncertainty so pervasive; and, finally, in no other industry is it as hard for outsiders to judge the quality of decision-making, at least in the short run. This industry is, in consequence, exceptional in the extent of both regulation and subsidisation. Yet this combination can hardly be deemed a success. The present crisis in the world's most sophisticated financial system demonstrates that.
I now fear that the combination of the fragility of the financial system with the huge rewards it generates for insiders will destroy something even more important - the political legitimacy of the market economy itself - across the globe. So it is time to start thinking radical thoughts about how to fix the problems.
Up to now the main official effort has been to combine support with regulation: capital ratios, risk-management systems and so forth. I myself argued for higher capital requirements. Yet there are obvious difficulties with all these efforts: it is child's play for brilliant and motivated insiders to game such regulation for their benefit.
So what are the alternatives? Many market liberals would prefer to leave the financial sector to the rigours of the free market. Alas, the evidence of history is clear: we, the public, are unable to live with the consequences.
An alternative suggestion is "narrow banking" combined with an unregulated (and unprotected) financial system. Narrow banks would invest in government securities, run the payment system and offer safe deposits to the public. The drawback of this ostensibly attractive idea is obvious: what is unregulated is likely to turn out to be dangerous, whereupon governments would be dragged back into the mess.
No, the only way to deal with this challenge is to address the incentives head on and, as Raghuram Rajan, former chief economist of the International Monetary Fund, argued in a brilliant article last week ("Bankers' pay is deeply flawed", FT, January 9 2008), the central conflict is between the employees (above all, management) and everybody else. By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks create gigantic incentives to disguise risk-taking as value-creation.
We would be better off with Jupiter's 12-year "year", since it takes about that long to know how profitable strategies have been. The point is that a year is an astronomical, not an economic, phenomenon (as it once was, when harvests were decisive). So we must ensure that a substantial part of pay is better aligned to the realities of the business: that is, is made in restricted stock redeemable over a run of years (ideally, as many as 10).
Yet individual institutions cannot change their systems of remuneration on their own, without losing talented staff to the competition. So regulators may have to step in. The idea of such official intervention is horrible, but the alternative of endlessly repeated crises is even worse.
The big points here are, first, we cannot pretend that the way the financial system behaves is not a matter of public interest - just look at what is happening in the US and UK today; and, second, if the problem is to be fixed, incentives for decision-makers have to be better aligned with the outcomes.
The further question is how far that regulatory net should stretch. I believe it should cover all systemically important financial institutions. Drawing the line will not be simple, but that is a problem with all regulation. It is not insoluble. The question the authorities need to ask themselves is simple: if a specific institution fell into substantial difficulty would they have to intervene?
If the conflict of interest that dominates all others is between employees and everybody else, then it must be fixed. All bonuses and a portion of salary for top managers should be paid in restricted stock, redeemable in instalments over, say, 10 years or, if regulators are feeling generous, five. I understand that the bankers will not like this. Yet one thing is surely now quite clear: just as war is too important to be left to generals, banking is too important to be left to bankers, however much one may like them.