CNN: Europe to cap bankers' bonuses
This is better than the other EU idea of paying bonuses in the form of bonds in the bank. That idea creates a situation where your average bankers's bonuses are decoupled from their own performance (usually, only the CEO and CFO of a bank can really have any sort of impact on a company's bonds). In which case, why pay a bonus in the first place if people don't think they can affect it and so don't value it? Obviously, there are a lot of people in favour of not paying bankers bonuses at all...that's a different conversation. But if you are going to pay a bonus, then it should be tied to performance properly, otherwise, people don't value it and it doesn't affect behaviour. It's better that they don't get a large portion of their bonuses until their investments are realised. That way, you prevent situations like all these subprime mortgages being issued. The employees wouldn't have gone for busted subprime if they knew their bonuses depended on it.
Disconnecting compensation from performance isn't just a financial services sector problem. A good example is with the public school system...teachers' salaries and pensions are disconnected from real performance, i.e. children's learning, so the schools are poor and the teachers push to reduce the standards on exams like the A levels so that they are made to look good even though it's to the detriment of the children. A friend of mine at Imperial College says most of her undergraduates' math skills wouldn't even be considered high school level in other countries, and Imperial's math programme doesn't accept students who haven't gotten Firsts with triple stars on their A levels...that's how dumb down the standards are now!
So how do you tie compensation to performance? So say the people working on the mortgage backed securities desks who caused the problems with subprime mortgages...their compensation should be based on how well those MBSs performed until maturity; they wouldn't have put dodgy subprime mortgages into the securities (or at least not to the extent that they did) if their bonuses would be affected...and that's something they have control over. Obviously, bonuses in financial services are high relative to other sectors, but the big issue that caused poor behaviour leading up to the financial crisis was that people were creating securities where the ultimate performance was years off but getting paid annually with no clawback. The banks should adopt more of the private equity carried interest model, where you have to wait until exiting investments before getting paid. It's been proven to address a large part of the problem (some private equity firms had difficulties, but none have gone bust).
For senior executives, they should be judged based on the things which have hurt banks the most in the past, i.e. asset-liability mismatch, poor credit quality, overleveraging, and mis-selling of financial products. It's not rocket science and it's nothing new; these are the 4 things which have caused ALL previous financial crises. For some reason, the regulators keep forgetting that.
One of my friends asked why politicians and regulators keep dropping the ball on this? My answer is "because they are susceptible to lobbying". Business is very good at convincing them that "this time it's different". Plus, the industry is pretty good at inventing new terms for the same thing over and over again in order to make things look sophisticated and justify why it should earn more. I find it amusing that many of the regulations the EU, UK and US are enacting now are the very ones they removed during the deregulation phase in the 1990s, when the bankers convinced the regulators that their sophisticated risk management systems meant the existing regulations were no longer necessary. The Glass-Steagall Act, the previous US regulation enacted after the 1929 crash, was working fine for years until it was revoked by the Graham-Leach-Bliley Act in 1999, only for most of the same provisions to be put back now by the Dodd-Frank Act. The UK, in some ways, is even worse. The British discovered after Big Bang deregulation that they could win financial markets business from other countries by offering more lax regulations. It's not surprising that it was the London-based units of Lehman Brothers and AIG which caused the downfall of their respective firms.
Really, I find the regulators make their lives (and everyone else's) too difficult with little benefit. Finance from a high level is pretty easy to understand. All regulators have to ask is:
1) Does this cause an asset-liability mismatch?
2) Does this reduce asset/liability quality?
3) Does this overleverage the company in a potentially unrecoverable way (regardless of the supposed "risk" level)?
4) Does this represent a mis-selling of what the financial product does, is overly complex or has higher costs than necessary?
You can basically eliminate all macroprudential financial regulation and replace them with these four questions. A Yes to any of them means the product shouldn't be allowed. It really is that simple...I'm willing to wager that there is no bad financial product out there that doesn't trigger a Yes to one of these questions.
The EU has been on a rampage in introducing new rules to constrain the risk taking banks can do. This one with capping banker bonuses at 2:1 versus salary has been in the works for a while. I actually have sympathy for this one, though I figure the banks will find an easy enough way around this one. At some point, the amount of bonuses some of these bankers receive just becomes funny money...they start blowing a few hundred thousand here, a few hundred thousand there...it's like a hip-hop star earning previously undreamt of amounts of money. They don't know what to do with it and don't know how to value it, except unlike hip-hop stars, they tend tend to bankrupt their companies rather than themselves.
This is better than the other EU idea of paying bonuses in the form of bonds in the bank. That idea creates a situation where your average bankers's bonuses are decoupled from their own performance (usually, only the CEO and CFO of a bank can really have any sort of impact on a company's bonds). In which case, why pay a bonus in the first place if people don't think they can affect it and so don't value it? Obviously, there are a lot of people in favour of not paying bankers bonuses at all...that's a different conversation. But if you are going to pay a bonus, then it should be tied to performance properly, otherwise, people don't value it and it doesn't affect behaviour. It's better that they don't get a large portion of their bonuses until their investments are realised. That way, you prevent situations like all these subprime mortgages being issued. The employees wouldn't have gone for busted subprime if they knew their bonuses depended on it.
Disconnecting compensation from performance isn't just a financial services sector problem. A good example is with the public school system...teachers' salaries and pensions are disconnected from real performance, i.e. children's learning, so the schools are poor and the teachers push to reduce the standards on exams like the A levels so that they are made to look good even though it's to the detriment of the children. A friend of mine at Imperial College says most of her undergraduates' math skills wouldn't even be considered high school level in other countries, and Imperial's math programme doesn't accept students who haven't gotten Firsts with triple stars on their A levels...that's how dumb down the standards are now!
So how do you tie compensation to performance? So say the people working on the mortgage backed securities desks who caused the problems with subprime mortgages...their compensation should be based on how well those MBSs performed until maturity; they wouldn't have put dodgy subprime mortgages into the securities (or at least not to the extent that they did) if their bonuses would be affected...and that's something they have control over. Obviously, bonuses in financial services are high relative to other sectors, but the big issue that caused poor behaviour leading up to the financial crisis was that people were creating securities where the ultimate performance was years off but getting paid annually with no clawback. The banks should adopt more of the private equity carried interest model, where you have to wait until exiting investments before getting paid. It's been proven to address a large part of the problem (some private equity firms had difficulties, but none have gone bust).
For senior executives, they should be judged based on the things which have hurt banks the most in the past, i.e. asset-liability mismatch, poor credit quality, overleveraging, and mis-selling of financial products. It's not rocket science and it's nothing new; these are the 4 things which have caused ALL previous financial crises. For some reason, the regulators keep forgetting that.
One of my friends asked why politicians and regulators keep dropping the ball on this? My answer is "because they are susceptible to lobbying". Business is very good at convincing them that "this time it's different". Plus, the industry is pretty good at inventing new terms for the same thing over and over again in order to make things look sophisticated and justify why it should earn more. I find it amusing that many of the regulations the EU, UK and US are enacting now are the very ones they removed during the deregulation phase in the 1990s, when the bankers convinced the regulators that their sophisticated risk management systems meant the existing regulations were no longer necessary. The Glass-Steagall Act, the previous US regulation enacted after the 1929 crash, was working fine for years until it was revoked by the Graham-Leach-Bliley Act in 1999, only for most of the same provisions to be put back now by the Dodd-Frank Act. The UK, in some ways, is even worse. The British discovered after Big Bang deregulation that they could win financial markets business from other countries by offering more lax regulations. It's not surprising that it was the London-based units of Lehman Brothers and AIG which caused the downfall of their respective firms.
Really, I find the regulators make their lives (and everyone else's) too difficult with little benefit. Finance from a high level is pretty easy to understand. All regulators have to ask is:
1) Does this cause an asset-liability mismatch?
2) Does this reduce asset/liability quality?
3) Does this overleverage the company in a potentially unrecoverable way (regardless of the supposed "risk" level)?
4) Does this represent a mis-selling of what the financial product does, is overly complex or has higher costs than necessary?
You can basically eliminate all macroprudential financial regulation and replace them with these four questions. A Yes to any of them means the product shouldn't be allowed. It really is that simple...I'm willing to wager that there is no bad financial product out there that doesn't trigger a Yes to one of these questions.
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