Jaimini Bhagwati: Are top bankers highly overpaid?

One way to contain egregious risk taking could be to stagger and cap annual bonuses.

In the last six months several leading international banks have acknowledged large losses due to their exposure to the US sub-prime market. In the face widening US$ swap spreads (the difference between triple A government and double A corporate interest rates) and weakness in the equity market the US Federal Reserve hurriedly cut the overnight benchmark interest rate by 125 basis points, in two installments, in the last week of January 2008. Later, at the G-7 finance ministers meeting on 9-10 February, 2008, renewed concern was expressed about higher than earlier anticipated sub-prime losses (now estimated at US$400-500 billion) and across the board credit market weakness.

Some financial sector CEOs have been dumped for their poor performance, e.g. the heads of UBS, Citibank and Merrill-Lynch. However, this is scant comfort to the thousands of Citibank and Merrill-Lynch employees who are being laid off while their erstwhile CEOs, Chuck Prince and Stan O'Neal, were paid $50 million and $160 million, respectively, for being sacked! In 2007, the average annual income for top international private equity and hedge fund managers was about $500 million.

The records of financial sector regulators in the US and Europe show that there have been several instances of fines imposed on some of the best-known names in investment banking and the hedge fund business for violating rules and regulations. In fact, there does not appear to be any other industry in which globally leading firms are indicted at regular intervals for breaking the law without any significant adverse consequences for them.

Recapitulating a few extreme cases of wrong-doing, Drexel Burnham Lambert's secret agreement with Ivan Boesky to defraud Drexel clients came to light in the mid-1980s. Michael Milken, who was a Drexel employee in the junk bond department, was indicted on 98 counts of securities fraud and sentenced to 10 years in prison in 1989. He served less than two years, paid $600 million in fine and is worth $2.1 billion today. In the mid-1990s, Nick Leeson's outrageous risk taking brought the venerable Barings Bank down and today he is on the lecture circuit after a short prison sentence in Singapore. Jerome Kerviel's unauthorised trading went on for at least all of 2007 before it was discovered in January 2008. And, it is likely that more than one Societe Generale risk manager was complicit with Kerviel. Except in the most extreme of cases, errant bankers lose their jobs but soon return to the job market. Obviously, it cannot be anybody's case that bankers are flawed human beings! It is just that "rogue" trading is to be expected if there are no lasting personal consequences for betting the house with someone else's money.

US banks and other well-known financial institutions have been periodically involved in high-risk activities, which have led to system-wide consequences. Central banks/governments are unable to tackle the moral hazard head-on and usually have no option but to enhance liquidity and/or provide financial support. Martin Wolf writing in the Financial Times pointed out that unbridled risk taking has a lot to do with the compensation incentives for bank management. The repetitive nature of these episodes, which are not always correlated with business cycle downturns, suggests that there is a tendency for bank management to look the other way if expected returns are considered to be high enough.

The potential for stratospheric bonuses induces investment bankers, including those involved with capital markets, to take higher financial risks than any other form of economic activity. For instance, compensation for fund managers is usually derived from a "2% plus 20%" formula. That is, 2% of the principal invested as service fees and 20% of the returns achieved above an agreed benchmark. Both numbers are usually higher for hedge funds.

Banks and other financial intermediaries add value by unbundling risk and parcelling bits out to those who are best able to carry the risk on their books. However, those who choose to retain substantial risk on their books should pick up warning signals in time. Systemic risk in the financial sector can extend to the real economy and hence the need to enforce discipline among market makers.

Institutional and high net worth investors do not complain when investment banks or hedge funds reward their employees with outlandishly high bonuses since these are funded out of profits. Hence it could be argued that huge bonuses for bankers should not be an issue. However, the fact that there are no lasting down-side risks at a personal level for bank managers even if an institution's entire risk capital is wiped out is asking for trouble. Any comparison with the limited liability that owners and managers enjoy in the case of registered companies is not valid since the potential for damage due to systemic risk in the financial sector is much higher.

Another argument which supports existing levels of compensation for bankers is that competition among financial intermediaries reduces returns to what the "market" is prepared to bear. In practice, however, barriers to entry result in banks being able to price their services at very high levels. Competition alone does not keep bonuses in check in the financial sector.

The too big to fail reasoning is often invoked in the case of the banks, hedge funds, insurance-pension companies and mutual funds. Raising risk capital requirements would do little to modify excessive risk taking if there is an implicit guarantee that in case the financial sector is at risk the central bank and/or government would step in. Further, increasing the intrusiveness and frequency with which regulators and auditors check financial statements will not resolve the "rogue" trading problem. In terms of specialised market skills, regulators will always remain a step behind the financial "engineers" in investment banks and hedge funds. Consequently, tighter regulation is not an adequate response.

Several commentators have recently suggested that bankers should be paid their bonuses on an ex-post basis over a suitably long period such that the financial consequences of their decisions become apparent. This should dilute the motivation "" get fabulously rich instantly "" but it may be difficult to assign accountability if disasters were to surface years after the event. On balance, one way to suppress the most egregious kind of risk taking behaviour in financial markets could be to stagger and perhaps even cap annual bonuses.

j.bhagwati@gmail.com