Friday, November 6, 2009

Another Downside of Limiting the Pay of Bankers

. Friday, November 6, 2009

A while back Alex and I went around on whether limiting the pay of bankers would make the system more stable. Jeffrey Friedman and Wladimir Kraus are asking the same question:

The real scandal of bankers’ pay contributing to the financial crisis is that nobody, literally nobody, has offered a shred of evidence that it did contribute to the crisis. Yet public opinion, the financial press, and the regulators have decided that it did, and drastic new regulatory policies are being constructed on that basis. Moreover, when we consult what evidence is known, it seems that bankers, far from deliberately courting disaster so as to boost their pay, unintentionally took risks that jeopardized their own wealth.

We can see some of the results in the huge hits taken by key bank executives, such as Richard Fuld of Lehman Brothers, who lost $1 billion by retaining his Lehman holdings until the bitter end. Sanford Weill of Citigroup lost half that amount. Ohio State economists Rüdiger Fahlenbrach and René Stulz have shown that banks whose CEOs held a lot of their banks’ stock fared worse in the crisis than banks with CEOs who held less stock. The CEOs who held stock in the riskier banks must have been ignorant of the risk, or they would have sold their shares.

Ignorance, not a perverse pay structure, also seems to have been at work at Bear Stearns. William D. Cohan’s "House of Cards" suggests that before losing about $900 million in stock when the bank imploded, Bear Stearns CEO James Cayne had no idea that anything was amiss. In fact, he was obsessed with the construction of a huge new headquarters building that would testify to the permanence of Bear Stearns, formerly the upstart of investment banks.


The available evidence seems to show that bankers were trying to be prudent:

Indeed, 93 percent of the mortgage-backed securities purchased by banks either were rated AAA or—better yet—were insured by Fannie Mae or Freddie Mac, with implicit federal guarantees. It turned out to be a mistake to trust the AAA ratings, but in making this mistake, bankers again demonstrated that they were not seeking short-term profits to boost their annual bonuses. Had that been the bankers’ aim, they would not have bought AAA-rated mortgage-backed bonds, which, being “safe,” paid a lower interest rate than AA- and lower-rated bonds. Bankers who were indifferent to risk because they were seeking higher return should have bought the more-lucrative, riskier bonds, but they did so only 7 percent of the time.


Alex might say "So what? The fact is that the crash happened, and now the government is on the hook for all these bad bets. Therefore the government should limit pay." My response is that it would depend: if the government assumed the contracts made by financial institutions, this should include compensation contracts as well. If the government didn't want to assume those contracts, they should have made that a condition of taking TARP money rather than re-writing the rules after the fact. There's a better case for limiting compensation contracts made after the government investment, but to my knowledge those are not the contracts under discussion.

Even more concerning to me is the fact that the internal practices of these firms have now become politicized. How is that a good thing for the firms themselves or the investment that taxpayers have made in them? Indeed, despite the president's assurances, we've already seen fairly drastic meddling in the auto industry which has led them to make poor business decisions for the sake of political expediency. Is that really what we want?

Finally, while none of us want to see another financial crisis, it will happen. When it does, we are now incentivizing banks to refuse any government assistance. This could make future crises much worse, and unnecessarily so. The government may also be handicapping itself: if it believes, or behaves as if it believes, that the real cause of the crisis was the incentives created by compensation contracts then it may miss an opportunity to reform the regulatory structure in other ways that could actually have positive effects.

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Another Downside of Limiting the Pay of Bankers
 

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