Bankers' pay and the bailout

Bankers' pay is a contentious political issue. This is inevitable, given the government bailout of the banks; and it's important to get it right. Here is one way of approaching the issue, as advanced by James Forsyth of The Spectator:

"It would be a sensible step if the government were to declare that a condition of any bank receiving public money would be that it does not offer a total compensation package to its employees worth more than the salary of the Prime Minister, £189,994. This is hardly going to put anyone on the bread line but it would show that there are genuine conditions to this bail-out."

This is far from being an outlandish view, but it isn't the right approach and it isn't going to fly. Here is my view on how the bailout, the regulatory environment and the issue of bankers' pay should be approached.

First, even without taking account of the bailout it is not credible to present the compensation of banking executives as determined by the market. Where boardroom pay is concerned, it is set rather by committees, on the advice of consultants who may even be appointed by the very executives whose pay is being decided.

Secondly, bankers' compensation has not necessarily been tied to their performance in any identifiable way. I think particularly of the use of stock options as a method of compensation, when much of the improvement in profitability during the boom years was nothing to do with management skill. Northern Rock is a case in point. The company's business expansion rested on borrowing money in the wholesale markets and lending it out as mortgages. This was a case of financial engineering rather than banking in any recognisable sense, and it came crashing to earth along with the housing market when the economic climate changed.

Thirdly, while those stock options provided lavish rewards in the boom, there were no costs when the business did badly. The options might even be repriced when the stock price declined. These incentives were perverse. Bankers had the encouragement to take risks during an asset price bubble but did not pay the price of failure.

So I have sympathy with the idea that the structure of bankers' compensation is in need of reform. But that's the point: it's not the rewards themselves that are the problem, but the way the rewards are (not) earned, and the absence of any penalty for such disasters as the selling of securitised sub-prime mortgage debt. Politically, I'm in favour of economic redistribution, through the tax system, to reduce inequalities; but there is no sense in stipulating absolute limits on compensation, because that will penalise legitimate enterprise and risk-taking.

Comments

[Rick Beekman]

Oliver;
seems like the U.K. has a mirror image of what the U.S. is experiencing.

Currently; One of the companies here in the U.S. who received the "bailout" benefits went on some junket and spent $400000. They enjoyed $1000 a night Hotel accomidations ete etc. Meanwhile we Peasents here are supposed to tolerate this and pay for it of course. Right now if it cost me $1.00 to go around the world; I'd only have enough to get to the City Limits Sign!!

As Marie Antoinette once stated; "Let them eat Cake" "Have you made our Reservations in Dubai yet"?

[Tony Francis]

An overlooked aspect of the sell-off are fears of a government completely in the hands of Obama, Pelosi and Reid. Conventional wisdom says it is the Republicans who are at fault. People with money in the market have been pulling out since the summer. We are told by Democrats that Obama has a superior plan. But so far, his plan consists of telling us how loopy McCain is. Where is Obama's plan? We are supposed to trust him. McCain hasn't helped. He is loopy. The more it looks like the neo-Marxists will be in charge, the lower the market has gone.
http://articles.moneycentral.msn.com/Investing/SuperModels/WhyWallStreetIsScaredOfObama.aspx?page=1

[David Duff]

With somewhat less of my usual bombast, because this is a subject about which I know little, is it not possible to provide top Bankers with stock bonuses which cannot be sold or transferred for at least 5 years? This, at least, would concentrate their minds on the medium rather than the short term.

[Gavin]

The evidence seems to suggest that leaving it to the markets to handle banker's reward packages will just leave us with the bankers and their appointees rewarding each other and making hypocritical claims about how this is justified by their personal 'responsibility' for profits; responsibility which vanishes when those profits mysteriously turn to losses.

Absent some form of government & statutory control which imposes some sort of genuine linkage between corporate performance and reward, the political backlash against this incompetent hypocrisy might well lead to even more problematic measures. In any case, and whatever the consequences, this is now a political issue which the mismanagement of financial services sector brought upon itself.

[Snorri Godhi]

I second enthusiastically Oliver's last paragraph. David Duff's proposal also makes a lot of sense to me -- although I suspect that what he suggests is already being done.

Let me suggest a modification of (or addition to) David's proposal: give bankers cash bonuses, deposited at the Central bank, earning interest of course, redeemable after 5 years if things go well, otherwise confiscated by the government to help pay for the bailout.

[Tony Francis]

Executive compensation is skewed by the incentives. If stock or stock options are rewarded, the goal becomes one of driving the stock price as high as possible. Remember the purpose of a business is simple: to provide a good or service in the most efficient way to produce the largest possible profit for shareholders. This may not correspond with stock price. Franklin Raines, while at Fannie, was rewarded based on the number of mortgages the company wrote. He had bonuses of $90 million in six years. We see where that got us. As Gavin has written, compensation boards are terribly inbred, and vote unrealistic pay packages. In the old days, stockholders had some say. Now, most stock in held by insurance companies, retirement funds and mutual funds. The managers of these don't care or don't pay attention to compensation practices. Usually, they are looking at the same thing as the corporate executives- how high can the stock price be driven? Government attempts to regulate compensation are likely to be counterproductive. http://www.en.wikipedia.org/wiki/Executive_compensation

[Tony Francis]

Democrats are rejoicing: the market crash is a total repudiation of the Bush years. The Democrats are finally vindicated, and the public is seeing it. Is this what is happening? Is this merely a sharp correction of the oil/housing/easy credit bubble? Read Barack Obama's plan for the economy:
http://obama.3cdn.net/6e85401e3caddd95cc_zecnmvshd.pdf
We are told Obama saw this coming. We are told despite Obama's great attempts to change things, he was thwarted by Republicans. Obama's plan: stimulate the economy with an additional $60 billion. Increase regulation and punish those who are in the market to make an unfair profit. Three of the six pages don't give us an economic plan, they just tell us McCain is a dolt.
The reality: people with money are voting on Obama and the Democrats. Their vote: no. Until Obama can inspire confidence in the investor class, we are doomed to economic doldrums. Talk of nationalizing banks, commodity markets, medicine, and all the rest are not helping. If you are a Marxist, it helps to have the money people behind you. So far, Obama is failing the economic confidence test. It is one thing to rally support from unemployed blue collar workers and 20 year old college students. It is another to rally the investor class. It is questionable Obama can ever do that, unless he and the Democrats change significantly.

[Tony Francis]

Paul Krugman is again calling for nationalization of the banks, and now commodity markets, as well. His comment is opaque, but the commentators posting on his article are calling for nationalization:
http://economistsview.typepad.com/economistsview/2008/10/paul-krugman-mo.html
Paul Volker, the old Fed Chairman and economic adviser to Obama says we have the tools to weather this crisis. His solution: end complex derivatives, and then, get some leadership. The new administration will have to inspire confidence to rebuild from the rubble. Really? This is his solution?
http://online.wsj.com/article/SB122360251805321773.html

[Laurence Witherington]

As Robert Shiller said to me recently, boards have every right to pay huge sums in order to snaffle who they perceive to be the top man. Often they have no choice; there is a finite amount of brilliance out there. However, what often happens is that the top execs do a great job at one firm, and when snapped up by someone else and given an astronomical salary, they become convinced of their own infallibility and under perform. A CEO pay bubble, if you like.

[Gavin]

Laurence, boards can pay whoever they want for whatever they want, provided the shareholders can actually hold them accountable before they use their golden parachute to escape the car-crash they steered their corporation towards.

And why assume the CEO actually has the direct influence on (good) corporate performance that you assume? Hiring the right name may make the board look good, but what actual relevance does it have to corporate performance which is often determined by external factors or the operation of the lowest common denominator below the executive level?

Hiring from the elite pool of witchdoctors doesn't change the fact that early detection and evasion of the upcoming problems are beyond the scope of voodoo and herd instinct.