[Reader-list] "regulators should intervene in banker's pay" by Martin Wolf

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FYI

Regulators should intervene in bankers’ pay

By Martin Wolf

Published: January 15 2008 17:35 | Last updated: January 16 2008 05:16

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” (FT, 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.

martin.wolf at ft.com

Copyright The Financial Times Limited 2008

cross-posted from DEBATE





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