Opinion

The Great Debate

Worry about bank capital, not bonuses

By J Saft
September 8, 2009

jamessaft1–James Saft is a Reuters columnist. The opinions expressed are his own.–

The effort to rein in banking bonuses, outrageous as they may be, is akin to banning glue sniffing because you are worried about the effects of intoxication.

There are, as the kids in the alley behind the high school can tell you, other ways of getting high.

Train your regulatory fire instead on requiring more and better bank capital and you will arguably do a great deal to control excessive compensation as well as doing much more to protect taxpayers and the economy.

Financial leaders from the Group of 20 rich nations agreed the skeletal outlines of a plan to reform banking last weekend in London. Included was the idea of claw backs on bonuses if earnings evaporate, forcing more pay to be deferred for longer, and more disclosure of top pay.

This may have some effect; bankers will have to wait a while for their money and some risky bets may not be made. But the out-sized rewards are the result of people within finance having an informational advantage over their shareholders and regulators and the ability to play with huge amounts of other people’s capital. Combine this with an implied government guarantee for the too-big-to-fail and you end up with a crisis every ten years or so. Just making bankers wait longer for their money does nothing to affect the competition for deals and assets to leverage.

Besides the folks who brought you the CDO squared will be well able to find workarounds to ensure that money leaks out in one way or another.

More promising by far are proposals to force banks to increase the amount and type of capital they hold. Central bankers and regulators from the Basel Committee on Banking Supervision are calling for a host of measures to bolster capital, including saying that common shares and retained earnings must be the mainstay of capital, introducing a leverage ratio and minimum standards for funding liquidity. All three will make banking and the economy more stable. All three will also, in so far as they reduce the amount of borrowed money available for investment, tend to push asset prices lower.

LEVERAGE IN, LEVERAGE OUT

Kansas City Federal Reserve President Thomas Hoenig points out that the largest 20 U.S. banks have equity capital equal to only 3.5 percent of their assets, as against an average of 6 percent for their middle sized competitors.

“They have an implied guarantee, which affords them an enormous advantage in terms of their use of leverage and their ability to accumulate assets to unprecedented levels,” Hoenig said in a speech to bankers made in August but released last week.

The large U.S. banks, it is worth mentioning, in turn face competition from their big trans-Atlantic peers, many of whom have leverage far in excess of theirs.

Forcing large banks around the world to raise enough capital, or dump enough assets, to put them on a level with their smaller peers would do a great deal to put an end to the rolling bubbles and bailouts.

The Basel committee also said it would consider the need for a capital surcharge to “mitigate the risk of systemic banks.” If by this they mean a tax on size above a certain level, this would be a fantastic start to counterbalancing the unfair advantage enjoyed by the too-big-to-fail, not to mention the threat they pose to the public purse. It would make good sense to impose a tax on size and to phase it in over several years, so that banks would have both the time and the incentive to shed assets without resorting to a fire sale.

Control leverage and size and you will do more to control destructive risk taking than any programme can which simply makes bankers wait a few years until they can get their payouts.

If you are really worried about unfair compensation in banking you have to define who is being badly treated by it. Moderating the effect of a taxpayer subsidy by limiting size and controlling risk taking is a start, but there are still shareholders and consumers of financial services to be protected. Both of these groups suffer because they don’t really understand the complex products being produced and sold by the industry. This allows consumers to be overcharged or oversold and shareholders to be chiseled out of part of their portion of the gains generated.

It is strange to say, but bank customers and owners may want to make common cause over the issue of simplicity in financial services. Simple banks with simple products might in the long run generate better outcomes for their owners and clients, just as simple index funds now do for investors. Will regulators be able to accomplish all of this? Probably not, but they would do well to concentrate their limited resources and creativity on the foundations of banking rather than the salaries on the top floor.

–At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. –

Comments
12 comments so far | RSS Comments RSS

A bonus should be for work well done – in the last two years there would have been very few!

Nothing wrong with having to prove performance before enjoying the bonus.

Posted by russ | Report as abusive
 

These do indeed seem sound, sensible, fundamental reforms, and ought be adopted internationally.

Posted by Atomik Weasel | Report as abusive
 

“akin to banning glue sniffing because you are worried about the effects of intoxication.”

Perhaps that just isn’t a very inspired analogy, but in any event, you really lost me right there. Seems like a pretty GOOD reason to ban glue sniffing, all by itself. If those alley kids know there are other ways to get high, then great, let them do it, as opposed to sniffing glue. If those other ways prove to be as dangerous as the glue, then we can ban those also as they become a serious problem.

I think it should work pretty much the exact same way in banking, as well. If these guys could get rich all on their own, they would already be doing it. Instead, they “allow” themselves to be among the best-paid employees in existence. Star-struck executives fall over themselves to hand these guys more cash, why? So they won’t go anywhere else? But if ALL these pay and bonuses packages were capped, then why would anyone want to leave in the first place? The only move that would allow them to make more money, potentially, is striking out on their own. And what’s wrong with that???

These guys are so superior and motivated, right? I would think they would STILL want to be known as the greatest financial minds in the business, even if they had maxed out on their compensation. No one is saying the caps would have to be ridiculously low, either.

Banking bonuses are a huge problem; they only provide excellent motivation to do what’s best for yourself at the expense of just about everyone else involved. There is no proof that I’ve seen, anywhere, that investors come out ahead when these aces are on the mound. Great overall returns, perhaps, but those returns are brought back to earth after the massive compensation is factored in. That seems to be the dirty little secret that few people want to talk about.

I have no real problem with the merits of your alternative proposals here. But the simple existence of other methods of banking reform and oversight don’t justify ignoring the huge problem of bonuses and the conflicting motivations they generate within the entire industry.

What’s good for any individual is great, so long as it isn’t extraordinarily bad for the country in the process.

Posted by pj thornton | Report as abusive
 

Thank you for writing this intelligent, proactive article. Populist opinion tends to demand claw backs and other retributive measures to satisfy public anger. Only forward looking steps, such as increasing reserve requirements or the tax you mentioned, will actually help prevent further bailouts and near-systemic failure.

Posted by Matthew | Report as abusive
 

Some simple points are very well made in this article. However, while addressing the systemic issues described in the article do take precedence, allowing the New Robber Barons to take out more than their public companies earn should not go unaddressed: individual crimes and systemic problems both require remediation.

Posted by Joeovercoat | Report as abusive
 

While Banking bonuses deserve every bit of ire the public can muster, they are unfortunately just a symptom of a far deeper and much more complex problem that’s taken decades to develop. Simply put, the income distribution system in the US is badly broken. Everyone from the President on down (or maybe up) to the Chairman of the Federal Reserve has acknowledged that the gap between rich and poor is troubling in both its magnitude and its rate of increase. Unlike some, I don’t believe it’s purely a taxation issue either. What we have now is the result of a perfect storm of sorts. Take the following decades-long trends and mix them together: the shift of our manufacturing base to lower wage countries, the explosion of entertainment and especially sports compensation beginning in the 1980’s and the cover it provided corporate executives (using completely erroneous comparisons) to increase their own pay packages in tandem, the incestuous nature of corporate governance where the same guys and gals collect hefty fees to sit on each other’s boards, and last but hardly least an economy that ended up offering easy credit in lieu of wages. So here we are. And as someone once told me: nothing new really, just a modern-day version of ancient Rome’s bread and circuses. Maybe, but look what happened to the Roman Empire.

Posted by Amandus Colver | Report as abusive
 

I’m sure the commentator considers himself to be quite moral and competent in his suggestions but he is neither. It is not either take back the bonuses OR institute corrective actions. It must be both. The published remarks show an embarrassing ignorance of the systemic nature of business as well as the essentials of human nature especially when it comes to the love of money. Deep inside the machine of industry, working folks know that nothing substantive has changed about the way we do business here in the U.S. It is immoral to reward those who make more than they need when those who worked hard to carry out the management’s wishes are being punished because the business plan, the plan that these detached executives crafted, was doomed to fail. Giving gifts to these incompetent few is like like handing an arsonist a match. First you take away the match. Then you get the arsonist some serious professional help.

Posted by Paul Aganski | Report as abusive
 

I would agree with Amandus Colver’s point with respect to the fact that we are witnessing a long-term systemic failure. Mr Saft’s suggestions seem to me sound and worthy of adoption.

The failures seem to me chronic, reflective of fundamental cultural values, and the course and outcome, barring miraculous intervention, quite predictable.

My expectation, frankly, is that given the momentum behind the failure modalities we are witnessing, and which pervade the society, we are destined for a truly great crisis, sooner or later, acute or chronic — indeed, one might well argue that we have had a gathering crisis for many years, and that it that gathering crisis is in fact reflective of deeply held American values.

I think it’s generally understood that America has been in decline for some time both in absolute and relative terms, and that this decline is unavoidable though it may be influenced to some degree at the margins.

American culture, with some exceptions, values the quick, the dirty, the shoddy, the quick fix, the quick buck, and has long felt that it is guaranteed preeminence because God is on its Side — the myth of American exceptionalism.

These are myths held only by the children of privilege, and they leave a culture infinitely vulnerable.

Perhaps divine intervention will save the Republic.

Personally, I wouldn’t place much faith in that outcome.

That said, Mr Saft’s suggestions are infinitely sensible, and we would be well advised to adopt them or something of similar sort.

Posted by The Not-So-Speedy Snail | Report as abusive
 

the problem with these bonuses is that these guys run the system and that system is geared for one thing and one thing only…to separate our money from us and give it to them. What EXACTLY are these guys producing? A collapse not seen since the 30′s. And they STILL deserve millions a year for this?

Posted by artofishalintelligence | Report as abusive
 

If one steps back for a moment and sees the issue from a historical perspective it will be obvious that the banking industry in the United States spared no effort in trying to subvert the Glass Steagall Act because of the constraints it imposed on them. It was this statute that kept these inept buffoons on a tight leash. This ensured their actions were kept in check and they were not free to run riot with nonsensical crap like the sub prime mortgages.

It was their good fortune that they got the ultimate manchurian candidate in the form of Mr Greenspan who {a} effectively rendered the Glass Steagal Act meaningless even before it’s repeal and {b} infused excessive liquidity in the system and then buried his head in the sand like an ostrich hoping things will right themselves. The ULTIMATE lesson of history of financial markets is that financial markets are characterised by greed and fear. Had he any sense, he would have acted decisively to ensure that Greed was kept in check. He did not, and now he has the gall to sermonize to the authorities in India that they too should adopt a policy regime which will foster the growth of BANKSTERS in India.

It is a sad time in the history of mankind that a people as industrious and hard working as the Americans have to live a life of indignity and want. It is even more offensive to the sensibilities when the people who caused this mayhem right from the managers to the policy makers live a life of opulence and are rewarded for being cerebrally challenged cretins instead of being made to suffer the same fate as they have caused to visit upon millions of ordinary people who just wanted to live a life of dignity and provide a better future for their families.

Posted by Ralesh | Report as abusive
 

“Thank you for writing this intelligent, proactive article. Populist opinion tends to demand claw backs and other retributive measures to satisfy public anger.”

Okay, so he obviously either works for a bank or is one of their PR lackeys trying to put a pin on the anger. The simple fact is is an industry cannot survive without a bailout, then NONE of their execs earned a bonus let alone their questionable paycheck. What should have happened had Bush and Obama spine and not in the pocket of the banks, they should have denied any bailout to any bank which didn’t put a three-year moratorium on bonuses. They (banks) cry free markets when they profit and run for socialistic bailouts when times are tough and still want their bonuses. They are nothing more than con men and thieves.

Posted by digginestdogg | Report as abusive
 

Banks with conservative minimum capital requirements, say 10-15%, make it.

Posted by Casper Lab | Report as abusive
 

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