Forget about bankers’ bonuses

September 17, 2009

Bank bonuses have been a red herring of the financial crisis, repeatedly deflecting attention from deeper problems. So it is disappointing that the leaders of the G20 nations propose to squander yet more time on the subject in Pittsburgh.

While the French may have recently watered down their proposed curbs on bonuses, their voter-pleasing plans still look likely to be at the heart of the meeting. Worse, they seem to be pushing aside the United States’ sensible proposals for tougher capital rules for banks.

Even so, there is a way of turning the tables on the French. Obama should make a powerful case for capital rules as a tool of social justice, which would moderate princely bank pay while shielding the taxpayer.

Curbs on bank bonuses are intended to serve two purposes. The first is to remove incentives for traders to take reckless risks in expectation of a lavish year-end payout. The second aim is social catharsis — to reduce overall compensation to more acceptable levels. The French plan would achieve neither.

If regulators give banks enough slack to take large risks, they will find a way of doing so. Even if bonuses were eliminated altogether, ambitious bankers could be encouraged by executives to bet the farm in expectation of a large bump up in basic pay.

It is also doubtful that rules on bonuses would really work: Financial institutions are masters at navigating their way around all kinds of regulations.

By contrast, America’s bank capital plan promises to get at the root cause. One of the chief reasons that bankers are overpaid is their bets are backed by an implicit government guarantee.

Before the crisis, trusting politicians stopped insisting that institutions hold enough capital in reserve for troubled times. Reinstate proper capital rules, and bank pay will certainly fall.

Obama can point to a historical precedent. In the 1920s, bankers earned a premium of up to 70 percent compared with similarly qualified professionals, according to a study by Thomas Philippon and Ariell Reshef for the National Bureau of Economic Research. This premium survived even the stock market crash of 1929.

But a slew of curbs on bank risk-taking and tighter capital requirements in the mid-1930s eliminated the gap between finance and other professions. Notice that there was no need for any specific regulation on bank pay.

The U.S. plans to bolster capital requirements have other advantages that could be easily sold to electorates worldwide.

A steep rise in bank capital rules is the best way of avoiding the need for socially wrenching bailouts of Wall Street titans. As the United States proposes, capital controls could be progressively tightened as banks get larger — encouraging institutions to shrink and limiting the “too big to fail” problem.

One reason the French may be more interested in populist diversions, is that the capital levels of European banks are so poor. While the top U.S. banks had an average leverage ratio of around 18 times equity in the latest OECD figures, leading European financial institutions had a leverage ratio of 37.

A rapid adoption of tighter capital requirements would plunge Europe back into deep recession. So America clearly needs to be patient with European leaders.

But the United States should be working harder to drag the spotlight away from the trivial question of bonuses and onto the more important issue of capital. This can be done by beating the French at their own populist game – a challenge Obama is surely equal to.


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