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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.

Comments

I agree that in a perfect world, anyone should be able maximize their income by any legitimate means. I recently read that the a major factor in the way bonuses are set at Goldman Sachs is that the company had long been a partnership so that the bonuses were a way of sharing the company wealth.

However, within the last year companies which received TARP shared the wealth via bonuses when it was not theirs to share. In fact, their response to TARP has been to hog far more in bonuses (at taxpayer expense) than their companies even earned. A substantial tax penalty (70% or better?) on these bonuses would net $Billions which could be used to buy back outstanding debt and discourage future feeding frenzies.

We now see that Marie Antoinette (“…Let them eat cake.”) and Leona Helmsley (“Only the little people pay taxes.”) are alive & well on Wall Street. The entire process has revealed that both parties have embraced Supply-side Reganonomics…Jack Kemp would be proud.

 

The government has created an artificial market by bailing out bankrupt banks. In doing so the current Labour government has sidestepped partial responsibility for the collapse. At least Alan Greenspan, the former Federal Reserve chairman had the integrity to admit a mistake. These banking organisations (and their employees) argue that without bonuses they will not be able to compete with other banks and similar institutions – in other words to compete in the market for the best employees. If many of these banks were truly left to compete in the market they would not exist, on the basis that they have failed. Any other business (in particular small to medium sized businesses) would have been bankrupt in a similar situation.
Now the government has created an artificial market whereby banks that are partially state owned (and in some cases fully owned by the government), continue to pay bonuses. In fact even those that are not state owned are in fact indirectly state owned by the way of the government backed insurance scheme, guaranteeing any future bad debts – many of these banks would not have survived otherwise. The recent spate of bonuses should go to paying back the tax payer, instead of the tax payer having to deal with cutbacks in public services and higher taxes. People involved in the banking industry are still arrogant enough not to see that what is happening now is not only morally wrong, but also against basic market principles which they claim they adhere to. I do believe that these banks should have been left to fail. I do not agree with the argument that allowing this to happen would have resulted in the economy collapsing. Those with guaranteed savings should have kept their savings (and correctly backed by the government), shareholders and investors should have been the ones to bear the burden of the banking collapse. They were content with their returns on investment when the banks were doing well, they should then be prepared to deal with the risks of those high returns. If they felt that the banks dealt fraudulently with their investments then this is a separate issue, they should have taken the banks and their previous directors to court to try and get back some of their investments. In other words let the market and law deal with the consequences. In fact we probably would not have the situation that those who presided over the collapse and disappeared when things went pear shaped would have been hunted down by investors.
The consequences: you cannot live by the market when it suits you, and when the market turns against you, go completely against market principles and create an artificial market financed by the government. Ordinary people will be paying for this for generations to come – in the meantime banks have not learnt any lessons. In fact we have now sown the seeds for future collapses. Banks will continue to operate in an unsustainable manor, lining the pockets of senior executives and major investors – because they have been given the green light by government. The government deficit will also have a negative impact in that other critical areas – the environment and global poverty will now take backseat to the deficit and its consequences. The banks would have survived but at what price to the country?
Nothing is free in life. The cost of propping up the banks will ultimately have an effect on Britain and the USA’s international competitiveness. This will enable Asia, other eastern countries and hopefully developing nations to take centre stage. So in the end the market will have its say.

Posted by Peter Jones | Report as abusive
 

This is why the banks should have never been bailed out in the first place. If they give away billions in bonuses, the company must be making a lot of money, of course they were given billions. When the bank goes broke because they gave away all their profits, it is the bonus program that is set up by whom?, that will be a big part of that banks failure. The banks that were responsible will still be operating. Don’t reward bad behavior. I know there is a lot more to this but the government should keep their nose out of businesses, and try to run their own. The government is doing a much worse job, look at the trillions we are in debt.

Posted by Tim Iowa | Report as abusive
 

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