This is not the ‘politics of envy’. Tackling the reason why some bankers’ pay, and risk taking, is too large is an imperative part of rebuilding banking for the future.
But even as politicians in the US House of Representatives stated that the “party is over” on Wall Street, the buyers of Lehman’s bankrupt banking businesses went on a bonus bonanza. Japanese bank Nomura has guaranteed not just to repeat last year’s bonuses to European and Asian bankers this year and next, but also to pay this year’s bonus wholly in cash.
Barclays is eschewing UK government money for, it is argued, more expensive Middle East money to preserve remuneration flexibility.
Clearly this is happening as bankers are able to show similarly generous offers from others in the City and on Wall Street. So why are senior banking executives unable or unwilling to discipline themselves and keep pay to affordable levels which do not put the whole system at risk?
This is not a Wall Street conspiracy – but rather it is a market failure created by the competition for money manager talent between two different types of institution: hedge funds and banks. The system fails because:
- Career concerns make traders crave large positions. Investment and deposit-taking banks employ traders who invest the bank’s balance sheet in the hope of making profits. Their pay depends almost entirely on the profits they make.
If the trader suffers losses of a large enough magnitude they lose their job. This is bad. But the pain stops there – larger investment losses do not have a commensurate effect on the trader’s payoff.
However, larger investment gains result in larger bonuses. Therefore a trade is overweighted on the upside. Hence, as is well known, limited liability makes the trader risk-loving.
But there is a compounding effect: increasing the size of the trading position comes at no extra cost to the trader but increases the upside when things go well.
So bankers prefer banks that will let them invest large sums. But this creates real risks for a bank.
- To attract the best traders, large bonuses must be available when investments work out. These can only be funded if the traders can take large positions.
So traders work for employers that will allow them to make the largest investments. If a bank unilaterally restricts the size of the investment its employees can make, it will end up hiring second-best traders.
- Equilibrium risk at the hedge fund level. There is a limit to the risk that senior bankers will allow their banks to be put under by traders taking larger and larger positions. If serious losses are suffered then the ability of the bank to generate profits from its other businesses can be compromised.
But hedge funds have no linked profits to lose as banks do. It is also easier to restart a hedge fund than it is to rebuild confidence in a bank. So hedge funds can tolerate larger risks than banks. They will therefore be happy to support larger positions and so be in a position to hire the best traders.
- Senior bank managers and shareholders’ interests diverge. Investment successes are shared in remuneration by the top banking executives before being shared with shareholders. While losses are borne first by shareholders before hitting the remuneration of the top brass.
Therefore senior bankers are happy to tolerate more risk than is ideal. With all banks doing this the banking system is more fragile than it should be.
In essence, investment bankers are incentivised by the bonus system to risk too much of the banks’ money. The banks go along with this as their pay is competed up by the hedge funds. This is a classic case of the hedge funds exerting a negative externality on the investment and deposit taking banks.
This is a market failure that individual banks acting alone cannot correct. The global financial system is currently dissolving from trader-induced losses on countless banks’ balance sheets. This is too important to be left unresolved.
As governments step in to bail out the financial system, now is the time to confront the market failure in bankers’ pay.
John Thanassoulis is a university lecturer at the university of oxford, official student (fellow) of christ church and senior tutor of the oxford university business economics programme.
