The restaurant-check problem and banker pay

October 1, 2009
TED has some great insights on banker pay, including this one:

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TED has some great insights on banker pay, including this one:

Deferred pay lost its effectiveness as a distributed risk management tool. As investment banks grew ever larger and more complex, each banker had less and less impact on the overall results and health of his bank, almost no matter how much he made.

This is the problem of restaurant checks. If there’s only one or two people dining, it’s relatively easy to keep the cost per person down. Even when the group rises to four or six, when everybody knows that everybody else is paying attention to what they’re ordering, things can remain within the realm of reason. But get a huge group of people together, all ordering individually, and things get out of control. Bringing down the cost of your own consumption has no visible effect on the amount that you’ll be asked to pay at the end, and so everybody pigs out.

The lesson, of course, is that investment banks need to shrink. If they do that, they can go back to being partnerships, rather than public corporations with growth-hungry shareholders. As TED puts it:

Because most of these outsiders were big, diversified institutional investors, they had an even more aggressive risk posture than the investment bankers themselves. They pushed the bank CEOs and Boards for ever more growth and return on equity, and the senior executives, being investment bankers who worship at the altar of revenue anyway, complied.

I’m with TED all the way up to his conclusion, where he seems to say that since reducing investment bankers’ pay wouldn’t be sufficient to solve incentive problems, it can’t be necessary. Maybe the existing structures work in small partnerships, and I’m happy to leave pay in small partnerships unregulated. But in large trading houses with 12-figure balance sheets, the incentive structure is clearly broken, and needs to be fixed. And since the banks won’t do it on their own, it’s down to the regulators to impose some kind of discipline. (After all, they represent the people who will bail the banks out should their bets go bad.)

Ideally, the regulators’ discipline will be harsh enough that investment bankers will leave to set up their own small-enough-to-fail shops, and the systemically-dangerous investment-banking behemoths will slowly go the way of the dinosaurs. And of course it will have to be reasonably well coordinated internationally, since investment banks are now global creatures. But I don’t think there will be any pushback from the Europeans on this front.


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