Martin Wolf: "Why regulators should intervene in bankers’ pay"

Martin Wolf’s current comment is great fun. He makes a recommendation which is logical and well argued but so contrary to the prevailing orthodoxy that it is sure to elicit a lot of ire. And I guarantee it will be misconstrued as well.

Wolf notes that banks (and we can include investment banks) have succeeded in creating crisis after crisis. Repeatedly, gains are private and losses are socialized. Even worse, as the current credit implosion in the US shows, big banking messes not only impose costs on taxpayers, but on the operations of the economy itself.

So what to do? Wolf says that while the powers that be can try better regulations, in the end those clever bankers will find ways to get around them, create new problems, and get bailed out again. The real problem is the incentives of the bankers themselves. The deals they do and trades they put on can and often do come a cropper in accounting cycles after their bonuses were paid.

In fact, some firms manage to institutionalize lack of accountability. When I had Citigroup as a client (admittedly many years ago), it would reorganize every couple of years, making it impossible to track the performance of any business over time, unless you hired a consulting firm to put together a P&L for a longer-term period.

Mind you, Wolf does not make a specific proposal beyond saying banker’s pay needs to be based on performance measured over a considerably longer term than a year, say via restricted stock grants redeemable over a horizon that could be as long as ten years. And he most certainly does not advocate capping pay.

Now some readers will howl, saying the talent will depart. Pray tell, where? Those who can decamp to hedge funds and private equity funds; they are small employment industries which will remain oversubscribed (until PE firms have their commitments cut, as did the venture capital industry in the wake of the dot-com bust, when they clearly had way too much funding relative to deals they could sensibly do. That in turn will lead to headcount reductions).

And some firms have done very well with long-term incentives, both in attracting and retaining talent and in achieving superior performance. Warren Buffet, in his insurance business pays his chief lieutenants 15% of the profits, calculated and doled out five years in arrears.

From the Financial Times:

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.

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  1. a

    I think you (Yves) have the right idea. Banks just need to hold a lot more capital. Double it or triple it. That will take care of the deals the bankers can do and the pay will come down of it itself (and prime brokerage will be much more costly to hedge funds, which will take care of their pay as well).

    In addition to more capital, banks need to be taxed much more, in order to pay for increased and better regulation. Current regulation is too hands-off and gives the bankers’ the benefit of the doubt. The banks are allowed to use their own models and systems to evaluate risk and these are considered validated if they backtest. The regulators cannot and do not try to analyze the positions independantly of the banks’ own systems, because they do not have the time or the ability. This is unacceptable. The number and standard of regulators need to increase dramatically (ten-fold?), so the deals can be analyzed.

  2. vlade

    I just had an idea. How about that banks (in return for bailing out) will pay the government a CDS fee based on the market CDSes for the bank? You get what you pay for, it’s clear and transparent, the CDS market for the banks is (relatively) liquid, so quotes can be had easily – and the govt. can’t be saying the banks are socializing losses.
    Of course, some “trivialities” (notional and how that should move, should it be rolling CMS deal etc..) would need to be worked out, but I’m sure that can be done with a good aproximation.

  3. The Epicurean Dealmaker

    Sorry, Yves, I believe Mr. Wolf’s recommendation is so hysterical, rambling, and contrary to common sense (and a fine regard for the facts) as to be risible.

    To the extent you are interested in a contrary (or dare I say contrarian) view on the topic, please see the counter to Mr. Wolf’s tirade I posted yesterday, after his piece appeared on

  4. Independent Accountant

    I am in partial agreement with Wolf. Any regulation will be evaded. Period. My answer: repeal the Federal Reserve Act and let banks fail. Make bank officers personally liable for bank deposits.

  5. puravidavid

    Free market touts are shameless hypocrites. They want to act with individual license for personal profit and when it leads to operating collapses, be salved by the loss of purchasing power for others.

    And yet they defend it with discredited nostrums? Priceless.

    The mood swing from lemming optimism to angry mob pessimism will likely leave bankers hanging from lamp posts or beheaded impaled on pikes with bloated tongues that once lied purple and protruding; eyes bugged out, sightless and dead.

  6. The Epicurean Dealmaker

    Puravidavid — No really, don’t hold back. Tell us how you really feel. Whassamatter? Short one too many Citigroup puts?

    Comments like yours make us “free market touts” look like sheer geniuses.

  7. ptstone

    I’m puzzled why the epicurean dealmaker thinks that requiring bankers to receive the largest part of their largesse in restricted stock which vests in 5 to 10 years would be a “highly intrusive, massively unwieldy, and extremely complicated regulatory regime”. Wouldn’t it be as simple as setting a salary cap and requiring that everything above that be paid in long-term restricted stock? Presumably, the cap could be set at a comfortable level, say $500,000 or $1 million.

  8. The Epicurean Dealmaker

    ptstone — Actually, I think what you propose makes eminent sense, and, in fact, is already in wide practice throughout the financial industry (or at least those parts where people make enough money to trigger your cap, like investment banking). For example, UBS announced relatively recently that it was capping cash compensation to its bankers at $750,000. Anything above that would be paid in stock or the equivalent.

    My objection was to Mr. Wolf’s proposal that external regulators enforce such a scheme from the outside, for the reasons I mention in my post and elsewhere.

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