Intervening in bankers’ pay

I attended a lecture recently given by Dr. John Thanassoulis from Oxford University.  His objective in this lecture was to explore the question of whether there is a case for financial regulation which intervenes in bankers’ pay.  To cut a long story short, Thanassoulis’s conclusion was that, yes, effectively the Government should intervene in bankers’ pay and cap it at an appropriate level to lower the overall risk of the banking industry.  Leaving aside who decides what “an appropriate level” to pay bankers is, in my view there are a host of problems with Thanassoulis’s analysis and conclusions.

Before getting into the problems I will describe Thanassoulis’s argument.  Fundamentally, he believes that the level of remuneration at banks is a legitimate source of concern because the higher the remuneration the greater the following:

a)      Restriction of bank lending

b)      Increased risk incentive for the banker

c)      Increased risk taking by banks in general.

Thanassoulis characterises these aspects as an externality (in other words a cost that others have to pay rather than the banks themselves) thus requiring intervention.  Interestingly, he views competition in the banking industry as a problem, because in order to compete for the best banking employees banks must pay higher remuneration thus increasing risk.  In his view, competition in a free market can sometimes be a problem. 

Thanassoulis’s analysis results in him drawing other bizarre conclusions.  Because he is concerned that that banking executives are overly concerned with the short-term (unlike say government regulators) and because bankers discount deferred pay, banks should be forced to defer pay to force bankers to focus on the long-term.  Secondly, remuneration should be capped to a proportion of assets under management or profits, nominally to lower risk but also to refocus banking towards lending.  Banks exist to lend money but apparently this is not sufficient motivation for them to actually lend money.  It is also not clear who is qualified to actually decide what the cap should be or who can define the long-term versus the short-term.  Is the long-term 20 years or three?  Is the short-term three months or one year?  How far into the future can one accurately divine?  That is a question for mystics perhaps or maybe left for analysis after the fact.

Oftentimes, when you find yourself making conclusions that on their face are absurd it is wise to go back and revisit your premises.  In this case, Thanassoulis’s basic premise is that for whatever reason bankers took excessive risks.  Fundamentally, he believes that bankers took excessive risks because they were incentivised to do so by their compensation package.  And furthermore, he seems to lump “bankers” into one homogeneous group when in fact, there are many types of bankers who perform various different functions.  Essentially, when many people think of bankers, they often seem to have in mind equity traders, a group I could imagine would fit the public image of an aggressive, all caution to the wind, testosterone charged bankers.  Indeed, Thanassoulis appears to refer interchangeably between traders and bankers without defining either.  The reality of course is far more complex.

Certainly commercial bankers (such as RBS, HBOS, Lloyds, who needed varying amounts of bail-outs) tend to be a much more genteel group than might be suggested by their public image.  The approach taken by such bankers to lending is consideration of the borrower’s ability to pay them back, whether this is over three years or twenty (long term?).  Simply put, banks will not lend if they do not believe there is a reasonable chance of regaining their principal.  It is true that during boom times a lot of loans were made that ex post have proven to be unwise, but the risks weren’t fully appreciated at the time. Bankers, like many individuals, conducted themselves as though the good times would continue to roll.  The issue here, therefore, is not excessive risk-taking but a misspecification of risk.  Commercial lenders base their specification of risk on actuarial models which unfortunately, can be biased based on recent events.  Furthermore, these models cannot account accurately for the business cycle, thus risk estimates are biased downwards.  As such, bankers are making loans based on a belief that the risk is lower than it really is. 

Furthermore, the very nature of banks allows them to have more funds available for these improperly specified loans than they otherwise would.  This is for two reasons.  First, modern commercial banks hold fractional reserves.  At the height of the boom period banks were holding perhaps 1% of deposits on reserve and lending the rest out.  Secondly, where necessary, the central bank would provide additional liquidity (i.e. print money to support banks’ lending).

And so not only was the risk estimate of lending understated, the amount of money available to lend was too high.  If banks have money to be lent it will be lent.  This is the modern function of banks.  The pressure on banks to lend will increase over time as profits that are made on earlier successful projects need to be reinvested.  This results in the banks increasing in size (due to increased asset values, new employees required to manage the multiplying projects etc.) necessitating further lending in a crowded loan market.  Furthermore the increasing esteem of banks provides further pressure to become involved in prestigious new projects.  These developments will also cause banking pay to rise and increase competition in the market to hire bankers.

Additionally, with a lowered perception of risk the interest rate charged to borrowers will be lower than it otherwise would be.  This in turn encourages companies and individuals to borrow money and invest in projects or spend on frivolities. Indeed, borrowers will also have a lowered perception of risk, essentially for the same reason as bankers.  And so while the cross-hairs of blame are centred on bankers, the same mistakes were made by all market participants.  HMV and Woolworths are two such casualties that borrowed money for investment in projects that ultimately proved to be wasteful. 

Fiddling around with bankers pay, capping it, deferring it, re-portioning it is a complete waste of time, trying to solve a problem that does not exist.  Bankers’ pay, its composition or amount, has nothing to do the causes of the recent economic bust, other than that it is merely another symptom of the business cycle.  Bankers are well paid because the economy is set up to reward them in this manner.  The majority of the financial resources in the economy are funnelled through the banking system and bankers take their cut.  This is because of the legal and economic structure in which banks operate.  That is, the central bank fractional reserve system.  Thus, in good times and bad, banks disproportionately benefit.

In any event, the compensation of banking employees is not a major source of risk in banking.  The major risk factors in banking include (but are not limited to) the risk of the project itself, market risk (i.e. movement in variables such as interest rates) and the gap between short-term borrowing and long-term lending.  If well paid banking executives steer the bank towards high yield projects it is because they have the appearance of being relatively low risk, not because they are anxious to take on high risk, high yield projects.  Unfortunately, they are unaware that the benefits from such projects are an illusion created by the very business cycle that banks perpetuate.

The obvious solution is to abolish every aspect of fractional reserve banking, including central banking and fiat currency.  This will not happen any time soon as it benefits the government to have this system in place.  The government has access to a hidden tax through inflation and a willing scapegoat when things go wrong.  The villagers will go armed with pitchforks and torches trying to kill the wrong monster.

Indeed, while complaining that banks are not lending, (after criticising them for lending too much!) the government assures that banks will not lend in any great amount by making it impossible to do so.  The low interest rate environment, created by that agency of the government, the Bank of England, has made it impossible for banks to exit many of their positions for many years.  But we should recognise here that the primary objective of the government is to ensure the survival of their colleagues at banks around the country (and by extension the world) and not either a quick end to the depression or lending to businesses that may or may not need the funds.

As such, John Thanassoulis’s conclusions are quite invalid and will not solve any particular economic problem.  Instead, he has fallen prey to the smoke screen promoted by the Government which has focused the causes of the depression on trivial issues like bankers’ pay.  Indeed, in this manner the Government takes advantage of feelings of envy amongst the population at large to focus their rage away from government policy and the fundamental causes of the depression.  This is slightly analogous to a similar method used with petrol prices.  When prices are too high, it’s not because of the approximately 150% tax on petrol but because of greedy oil companies and price-gouging petrol station owners.