Why oh why is it that the US media treats financial services compensation levels as a third rail issue? Rent extraction was the driver of the financial crisis, and the financial services sector made it clear in 2009, by paying itself record bonuses on the heels of being saved from certain death, that it had no intention of exercising any self restraint. The entire sector received massive explicit and back-door bailouts, from equity injections to fancy facilities to engineering a steep yield curve. The UK’s FSA, getting some cover from EU regulations that require curbs on industry compensations structures, is moving forward on the compensation front (by contrast, US pay czar Ken Feinberg’s efforts to shame a narcissistic industry was destined to be only a PR exercise).
The FSA’s efforts arguably fall short of what is needed. As we and others have noted, banks did not start running off cliffs en masse until the sovereign debt crisis of the late 1970s, one of the first misadventures of the deregulated era. And the savvy, high rolling parts of the industry did not exhibit this sort of costly behavior until investment banks had gone public and were working with other people’s money. As we discussed in ECONNED, partnerships provided for vastly better incentives. The most obvious inhibitor of reckless behavior was the unlimited liability (if the firms lost money, its partners were on the hook personally). But that wasn’t the only one. Partners typically had the vast majority of their wealth tied up in business, and they could withdraw it, only gradually, after they retired. This illiquidity produced a long-term perspective and conservatism about who was made partner. While it would be well nigh impossible to dial the clock back, measures that defer payout and increase individual liability are steps in the right direction.
Now some readers may argue that the FSA’s latest move, which expand the reach of its efforts to curb out-of-line compensation to hedge funds and investment managers, is overreaching. But that perspective is too narrow. In a world of a government-backstopped financial sector, combined with tightly coupled financial firms and markets, any firm close enough to the financial water mains can do damage. Pre-crisis, anyone who forecast that safety nets would be extended to money market funds, investment banks, and a big insurer, or that the CDS market would effectively be backstopped would have been deemed utterly daft.
The problem, ultimately, is that there is no neat cordon sanitarie between the firms enjoying explicit or presumed government support (anyone with an operating brain cell knows Goldman, for instance, will not be allowed to fail) and their counterparties. That was the lesson of the LTCM near-death in 1998, yet no effective measures were put in place then. And the fact that backstopped firms channel funds to non-backstopped firms and thus support risk-taking in less regulated parts of the system is a long-recognized problem. The most radical and effective measure is narrow banking, or restricting depositaries to investing in only very safe assets, first proposed by Irving Fisher and others during the Great Depression.
Put more simply, who benefits from the leverage provided by the backstopped financial firms? At a minimum, any market participant that uses leverage provided off exchanges (which means explicit borrowings, such as through prime brokers, say via repo, and by using OTC instruments that allow for leveraged exposure, such as options). And before readers start caviling that XYZ Fund doesn’t work that way and is being included unfairly, consider: every investor in risky assets is enjoying profits that are higher than they would otherwise be thanks to central bank (so far at best partly effective) efforts at pump-priming. That’s a de facto subsidy. All these restraints are achieving is at best partial blunting of corporate welfare programs.
From the Financial Times:
The Financial Services Authority, which has sought to set the global standard on responsible pay practices, is broadening the scope of its remuneration code from 27 large banks to more than 2,500 financial services companies, including the UK branches of many overseas businesses…..
The US, Switzerland and much of Asia have signed up to global principles linking pay to risk but their rules have been less onerous…
But the FSA’s interpretation of the EU law holds some comfort for the industry. That directive requires companies to defer 40 to 60 per cent of bonuses for three years or longer and does not specify who is covered.
As adopted by the FSA, the pay rules apply to senior managers and employees whose activities may have a “material impact” on the company’s risk profile. The higher 60 per cent deferral rate applies to bonuses over £500,000 (€596,000, $780,000).
The FSA also rejected an interpretation of the law being put forward by members of the European parliament that would have limited upfront cash to 20 per cent of the total package – the strictest rule of its kind in the world.
Instead the FSA’s revised code says that at least 50 per cent of the total package must be paid in shares or share-linked instruments.
Update 3:30 AM: Philip Stevens’ comment is germane:
Political resolve has given way to fear. No one waxed more eloquently than Mr Sarkozy about the iniquities of liberal markets. This was the moment, the French president told us, when capitalism would be remade in the image of the European social market. All this, though, was before the Greek sovereign debt crisis saw the eurozone under siege. Now Mr Sarkozy lies awake each night worrying that France might lose its triple A credit rating.
He is not alone. As they struggle to reduce huge budget deficits, western politicians almost everywhere are in thrall to global capital markets. David Cameron has made no bones about it – Britain’s prime minister says he is slashing spending on the welfare state and paring back the nation’s global role because the Bank of England has told him that the rating agencies would be satisfied with nothing less.
The rating agencies – remember them? Some may recall that these very same organisations were deeply complicit in the chicanery that saw worthless debt instruments repackaged as top-notch financial securities. I am sure I heard the politicians say they would be cut down to size. It never happened. The rating agencies never repented; and now they are masters again….
Financial institutions are still extracting large profits from trading activities described by Lord Turner, the head of Britain’s Financial Services Authority, as inherently useless. Lord Turner, however, has been almost a lone voice in suggesting a fundamental rethink.
The crisis in the eurozone shows how the herd instincts of capital markets can destabilise an entire continent. The consequence has been to push European governments into a premature, and risky, race to slash fiscal deficits before economic recovery is assured.
With a little help from the regulators, the big banks can now declare themselves duly stress-tested, but the systemic instabilities remain. International markets have moved far ahead of the capacity of political leaders to understand, let alone properly oversee them. This failure of political governance to keep pace with global economic integration is as apparent now as it was in 2007.
Even if politicians better recognise the risks of interdependence and the vulnerabilities of particular institutions and financial instruments, they are far from any consensus on how to share responsibility for global oversight. So, three years on, things are much as they were – except that most of us are poorer. The markets rule. OK?
Yves again. It’s worse than that. Not only are the non-banksters poorer, but the perps now have mechanisms in place to assure that the next round of looting will go more smoothly.