Banking pay

As I write this, the UK FSA are publishing decisions about guidelines and rules in respect of banker pay, issues which have come to the fore during the financial crisis after bubbling away in the background for a number of years.

The arguments in favour of bankers being paid substantial sums in terms of bonuses are well-worn ones. First, there is the argument that banks must pay the market rate for ‘talent’ or it will go somewhere else, and either that individual institution, or the economy as a whole, will lose out. We can call this the ‘market rate’ argument. Second, there is the argument that, in order to incentivise bankers to innovate and come up with new financial products and services, that we have to offer them lucrative bonuses to encourage them. We can call this the innovation argument. Third, there is the argument that certain bankers create incredible returns on their activities, and so it is only fair that they receive a share of that return. We can call that the ‘fair share’ argument. Do these arguments stand up to any scrutiny.

First the ‘market rate’ argument. This depends on labour markets working efficiently, and of money being a substantial incentive for those working in banks. If markets don’t work efficiently then rewards go to the wrong people, and if money doesn’t incentivise bankers then paying them more is a waste of money – they would have done the same work for less.

The argument about efficient labour markets in banking presumes we are able to identify good performers from bad ones, and that good performers should command a premium. However, there are disquieting claims that good financial performers might just be rather lucky rather than brilliant. Taleb’s ‘The Black Swan’ and ‘Fooled by Randomness’ are the most popular version of this claim, suggesting simply that, as there are a very large number of traders, some are going to be very successful period after period not because of their ability, but because of blind luck. It might well be that traders receiving extraordinary rewards are just extremely fortunate. Equally, if bankers pay is bid up in periods where high rewards are being made, what about in periods where losses occur. In such periods should bankers receive substantial cuts in pay, especially where their organisations have been bailed out by taxpayer’s money. In such times, we are told, it is more important than ever to pay high rates to make sure that the best bankers remain in firms to make good losses and to ensure public debts are repaid. This seems rather like trying to have the argument both ways to me – that in boom times bankers should be paid highly, and in bad times they should be too. This isn’t any kind of market logic – that would suggest that in bad economic times bankers take substantial pay cuts. Until such a time as this happens, it’s hard to take this argument seriously.

The second part of this logic is that money incentivises bankers. This seems, on the surface, to be an obvious thing – of course it does. However, I’m not sure how far it extends as bonuses get bigger and bigger. The law of diminishing returns would suggest that bonuses have a limit beyond which they achieve nothing. If you pay me a £2 million bonus rather than £1.5 million, am I going to work proportionately less? There may be a collective action problem here – that you pay me £2 million because you think I might leave if you don’t, and so everyone is forced to pay this much as a bonus. But this goes back to the first part of the market rate argument, and is less to do with the market than an inherent belief that labour markets in finance are inherently efficient. If there is good reason to doubt this is the case, then the argument doesn’t work. Equally, it seems to assume that bankers are only interested in financial incentives, and pay little regard for the quality of their experience at work, their colleagues, or any of the other reasons why we work for who we work for. This surely doesn’t stand up to much scrutiny.

Next, there is the innovation argument, that bankers need to be paid substantial bonuses in order to come up with brilliant new financial products and services. This seems to suggest that banking is such a terrible job to have that, only by incentivising people through the use of blunt cash can we get them to do their job well. Is this really the case? This would seem to make the case that bankers aren’t terribly professional, and don’t take much pride in what they do. I hope this isn’t the case – and if it is, the perhaps why ought to be thinking again about how we organise banking. Either way, I don’t think the argument works.

Next there is the ‘fair share’ argument. This one doesn’t really work either. This is because bonuses are often linked to performance, and what we’ve learned over the last couple of years is that bank ‘performance’ is a far from obvious concept. Banks seem to have exposed themselves to considerable risk, leveraging themselves far beyond any sensible level, with considerable implications for us all since the credit crunch of 2007. In the years prior to the ‘crunch’ bankers appeared to be generating substantial profits on opaque financial instruments, and paid themselves massive bonuses on that basis. But these profits have often proven to be rather illusory, paper-based rather than adding any long-term value to the economy as a whole. They may even have been wholly illusory – think of the trillions that have been wiped out over the last two years. Banking bonuses, it seems to me, should be linked to the long-term value of assets such as shares rather than short-term profits. This might also have the effect of making bankers more loyal to banks, and so giving them less of an incentive to want to change banks on the grounds that their bonus is only £2 million and not £3 million – it might bring an end to this kind of nonsensical thinking.

Equally, the ‘fair share’ argument should apply both ways if it is to apply at all. If bankers are to get shares of the profits they generate, should they also get shares in any losses? It seems unreasonable for them to gain only the upside of the risks they take without having to participate in any downside. Only by linking bonuses to long-term performance can both upside and downside be taken into account, and bankers encouraged to create tradable assets of real value rather than those designed only to achieve short-term gain.

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