Ideas@TheCentre

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Bureaucrats will do an even worse job of setting executive pay than banks

Jamie Whyte | 10 April 2009

Getting tough on greed! It is a perfect headline for a politician. Kevin Rudd, Gordon Brown and the other world leaders at the G20 got it last week with their promise to ‘implement the Financial Stability Forum’s tough new principles on pay and compensation’ for bankers.

Alas, the policy is not as good as the headline. The financial crisis was not really caused by bankers’ greed. And the FSF’s ‘principles for sound compensation’ are ill-conceived. They will merely create a new set of perverse incentives in banking.

Start by asking the basic question. Why would greedy bankers take excessive risks? Bank managers typically receive a large portion of their variable pay in shares. This is designed to align their interests with the interests of their employers. By enriching himself, a greedy manager will also be enriching his bank’s shareholders. Gordon Gecko was right; aligned with the correct incentives, greed is good. It makes managers do the right things, including taking the right amount of risk.

A company’s share price is determined by its expected profits, from now until eternity. Greedy managers who are paid in shares cannot afford to take a short-term view, as Rudd, Brown and the rest claim they have. If short-term profits are earned by taking disproportionate risks – risks that are likely to lead to massive future losses – then the share price will fall immediately.

Bank managers took excessive risks not because they had short-term incentives but because, in the years before 2007, the credit and stock markets failed to ‘price in’ those risks. If not for this failure, banks’ cost of capital would have begun to rise, and their share prices to fall, much earlier. Bank managers seeking to maximise their bonuses would have reduced the risk-taking that caused the current crisis.

This failure to accurately price risk had many causes, such as the complexity of modern financial products, explicit and implicit government guarantees to depositors and an over-reliance on historical data in risk-modelling. But the way bankers are paid is not among them. That is why the FSF’s principles for ‘aligning compensation with prudent risk-taking’ are both pointless and dangerous.

Jamie Whyte spoke last night at the CIS Crisis Commentary, Bankers As Bogeymen: Why Salary Regulation Won’t Help the Crisis, in Sydney. This is an extract from his opinion piece in The Australian.