Saturday, 13 July 2013

Economic Foolishness: The Truth About Bankers' Bonuses & Government Subsidies

If you’re looking for an area in which the most nonsense is spoken by the most people on any one subject, a good candidate has to be the financial crisis and the spurious ideas surrounding caps on bankers’ bonuses and Government bail-outs. You’ll hear politicians talking about how the banks needed more regulation, how bankers’ salaries and bonuses need capping, and how they were reckless in focusing on narrow, short-term visions rather than the supposedly preferred long-term incentives. The politicians are confused; they've got it wrong here on just about every level – but just as bad, they’ve not offered any example of a reasoning process to lead them to this conclusion, they’ve just assumed that because there was a financial crisis that this must mean bonus caps and more regulation will make things better. They won’t, they will make things worse.  Of course, the majority of the electorate also think that bonus caps and more regulation will make things better, so our MPs don't really have much of an incentive to understand where they're going wrong.  Unlike politicians, I will give you a clear and accurate reasoning process that demonstrates why bonus caps and more regulation won't make things better.

What politicians want to propose is that bankers’ deals are constrained by revoking bonuses if the borrower defaults or the deal collapses. They think that with the threat of bonus revocation bankers will be less reckless – but they have their reasoning backwards, they will actually be more reckless.  Let me first explain why it is incorrect to say that senior bankers have very narrow, short-term visions.  A significant proportion of bankers' bonuses are commensurate with the share prices of the bank (they are paid either in shares or in cash), where those share prices are determined by forecasted profits. If a banker undertakes disproportionately risky deals to obtain short-term profits then the forecasts will likely predict much bigger losses in the future, which means share prices will immediately drop.  Hence, managers paid in shares cannot afford to risk the narrow vision.

The banking risks that brought about the financial crisis were down to excessive gambling because the credit markets and stock markets didn't factor in those risks. Had this failure not happened, banks would have seen a rise in the cost of capital and a drop in share prices much sooner, giving the natural incentive for bankers to reduce the risk voluntarily to maximise their variable pay.  

The Government's regulatory proposals are a disaster, and tangible evidence that they don't understand economics.  Here's why the regulatory proposals will increase recklessness not decrease it. Suppose we take the state's advice and award variable pay when profitable ventures are completed instead of at the point of making them - it's pretty clear why that won't help things. Consider corporate lenders A and B who each lend out £1 million to 2 identical clients on a 4 year plan. With Government regulations, any bonuses A and B procure on the deal should be deferred until the 4 year period is up, subject to the loans being fully paid off. If A's client defaults within that time period then most politicians think A should receive no variable pay. Here's the problem; how on earth can this improve A's decision-making? At the time of lending, the known risks presented by the 2 clients were factored in to the deal. It is a combination of varying factors way beyond the lender’s foresight that client 1 turns out to be one of the few that ends up defaulting. The risk is taken at the point of the loan, not at any time thereafter - so it is ludicrous to try to improve initial analyses by basing variable pay on unforeseeable future circumstances.

Such a proposal does not adjust risks, it adjusts unforeseen consequences - so it would be crazy to evaluate financial restitution based on such factors, because it increases bankers' incentives to heighten risks. If they have to wait for the culmination of repayment you'll see a huge increase in risky deals because a great proportion of loan deals are low probability of high loss, so lenders might as well make more deals, particularly as the cost of huge losses won't be incurred by bankers' themselves but by bail-outs.  The way to incentivise bankers to calculate the risk more diligently when making loans is to have them bear the cost of that risk at the time of making the decision by imposing a banker's insurance premium for the risk that that decision engenders (this is how banks insure using buffers for capital, where a premium for every loan can still be weighed).

Suppose the lender was paid variable pay equal to 10% of his contribution, where "contribution" means the interest margin he earns from the loan minus the premium charged to insure against the risk of the loan defaulting - the banker will have an incentive to only make the loan if the interest margin is greater than the cost of the risk-insurance. The bankers' role would be to calculate these loans using a risk analysis, and make the ones that seem economically viable, enjoying their bonuses on the profits, and bearing the costs on the losses. If you underestimate the risks then the insurance premiums will be too small, and there will be excessive lending - but this issue isn't solved by changing variable pay and bonuses, it is solved by improving the calibration of risks in the first place.

Next, most politicians think that high-paid, big-gambling bank managers are the real failure of corporate governance. They are not - it is the other way around - it is low-paid, risk-averse bank managers that are failing the system. Firstly, managers tend to take fewer risks than shareholders (despite most people thinking the reverse is true), as most shareholders have diversity in stocks that are not correlated with each other, so all the eggs are not in one corporate basket. Managers on the other hand more often have all their managerial eggs in the basket of the company for whom they work, so if their company fails they'll lose their salary plus any company shares they own.

In a healthy system then, big bonuses, therefore, have the positive effect of increasing appetite for risk - which is a good thing because if risks pay off then appreciation of equity increases hugely, whereas if the risks don't pay off, the most the shareholders can lose is the value of the shares they bought (in other words, a few eggs in their basket). That is why shareholders benefit from risk, and why they want managers whose appetite for risk is voracious (the best way to achieve this is if when it comes to shares owned in companies managers have diverse portfolios).  

Ah, but I’ll bet you have a burning question; what stops the risk culture going out of control and becoming a culture of recklessness?  What stops (or should stop) companies engaging in crazy lending is that a company's creditors (either a single investor or another company) have a claim on the services of the company taking risks, by providing something (a property or service) under the contractual agreement.  As creditors don't share in the company's profits they don't gain from their company's risks - which is reflected in the risk premium agreed by the first and second parties (it is the increasing cost of borrowing that places constraints on corporate leverage and other risky ventures). This ought to make it crystal clear why Government bail-outs and guarantees are mostly a terrible idea - and why they only increase the incentive for risk-taking. Put it this way, if you stake your house on a deal and it goes wrong you're going to be hugely out of pocket and asking a friend for lodgings. If you stake your house on a deal and it goes wrong but is under guarantee by the Government, you get another house at the taxpayer's expense. It's pretty obvious which deal is going to elicit the most careful analysis before it is finalised.

And the last point, a mother would be foolish if she kept buying her young son lots of cakes and chocolate and then complained that he’d got fat.  But if a boy wants lots of sugar he cannot be blamed for accepting his mother’s sweet subsidies.  Similarly, a company's executive who rejects Government subsidies does something irresponsible because he drives down the value of his company's shares. Given that a Government's guarantee of bank deposits severely reduces the risk premium that banks must pay on their debt capital, it is clear that these kinds of bail-outs are unadvisable, and bad for the general public, who as taxpayers benefit much better when markets are left alone. When the Government acts as a creditor they won't often demand higher interest rates commensurate with risk-taking, which is why it is better when non-Government creditors incentivise against foolish risk-taking by reining in recklessness. To prove the point, here's a fact you may not know - in the past 35 years, of all world's largest financial institutions that have failed, over 90% of them have creditors that suffered no significant loss due to Government bail-outs. This basically amounts to a Government subsidised risk encouragement, by removing or depleting the standard market risk-taking discipline that creditors charge.  It's a shame politicians that think this way are in charge of our country.

* Photo courtesy of