FSA barks up wrong tree on guarantees

July 21, 2009

The Financial Services Authority has since the credit crunch had a bee in its bonnet about the incentives and rewards offered by financial firms and whether these encourage risky behaviour. It’s a perfectly reasonable concern. Big bonuses probably did skew behaviour towards excessive risk taking in some cases, although the crazy risks run by employee-shareholders at Bear Stearns and Lehman Brothers suggest it might be a more complex picture.

But the FSA’s latest campaign — against long-term bonus guarantees — simply doesn’t make sense. The regulator has written to more than 40 chief executives in the financial services industry warning them against offering bonus guarantees with a duration of more than one year. This is “inconsistent with effective risk management”, the letter states.
The whole idea of guarantees is of course a loaded one in the wake of the crisis. Some feel that bankers have come through it in better shape than their shareholders.

But one has to question whether the FSA is wise to stray into this area at all. Bonus guarantees are largely used to lure employees with special knowledge or skills to move their “practice” from one firm to another. The extent to which banks should invest in building up in a new area in this way is surely a commercial matter for them and their investors. It should only be a matter for the regulator if the level of investment is so big that it might imperil the whole business.

It is also very questionable whether guarantees do encourage risky behaviour. Arguably they do precisely the opposite. After all, employees who must earn their bonuses have an incentive to take risks. Their pay will be meagre if they do not. But a long-term guarantee, for all its shortcomings, actually encourages risk aversion. If employees have been promised the full rewards up front, their objective is to avoid being fired — not to shoot the lights out.

Again, the regulator should only involve itself if and when guarantees — as a proportion of a firm’s total compensation bill — reach such a scale that they make its cost base less flexible, thereby limiting its ability to adjust to changes in markets.

This is not an argument in favour of bonus guarantees. But they are a commercial tool that should be available to employees of a people business. The FSA should keep its powder dry for more important battles, especially ones where it can actually enforce its own decision (which is doubtful in this case). That said, with the opposition Conservative party threatening to give it the chop anyway, it may not have many more to fight.

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