Bankers’ Pay On the Line Again

The people who run big banks in the US have had a good year. They pushed back hard on financial reform legislation during the spring and were able to defeat the most serious efforts to constrain their power. They and their non-US colleagues scored an even bigger win at Basel this fall, where the international committee that sets financial safety standards decided to keep the required levels of equity in banks at dangerously low levels. And the counter narrative for the 2008 financial crisis, “Fannie Mae made me do it,” gained some high profile Republican adherents closely aligned with the men who will control the House Financial Services Committee in 2011-12.

But there is also a potential lump of coal in Santa’s sack for the biggest banks, in the form of restrictions of pay – both its structure and perhaps even the amounts (although officially the latter is not currently on the table).

The impetus here comes not from American “populists” of any kind – although reformers of left and right have been pushing for progress on this issue since massive bonuses were paid out by firms that were saved by the taxpayer in fall 2008 (and again in 2009 in some cases). According to the Wall Street Journal, for 2008 there were nearly 5,000 bonus payments in excess of $1 million at “the largest US banks that accepted Treasury aid.”

Rather the push to constrain bank executive pay comes from officials and the political elite in continental Europe – supported by an increasingly effective pro-reform group around the Bank of England (led by Mervyn King, the governor). There is also supportive language in the Dodd-Frank financial reform bill, although this by itself rather vague and completely open to interpretation by the regulators.

Still, the overall proposal is entirely reasonable and well thought through at a general level: “lock-up” a considerable fraction of bank bonuses until we see, after several years, exactly how the banks do.

The issue, of course, is that banks (with their ludicrously low levels of equity; if this point is not clear to you, see this primer) can juice their returns considerably by taking on more risk. These risks may not be apparent for quite a few years – depending on how long it takes the credit cycle to run its course. Eventually, if those risks threaten to bring down one or more big banks, there may be a rescue by the taxpayer – and there is nothing fair or politically palatable about that.

Bank executives hate the idea that their pay will be constrained in any way. In Europe, where bankers are less powerful than in the US, they have already lost this battle – although there is still a lot of a fighting about details and implementation to be done.

In the US, as we head into 2011, expect to see three types of pushback from the banks’ very sophisticated PR machines.

a) “We already ended Too Big To Fail”. But we didn’t, at least for the global megabucks that would be subject to these compensation restrictions. There is no way to handle the failure of a cross-border systemic bank, although than through Lehman-like collapse. The case for stronger preemptive action to reduce system risk is overwhelming.

b) “This would weaken us relative to our global competitors”. Not really – given that it is the regulators of our main competitors who are initiating this move. To be sure, Chinese banks are not likely to follow suit, but that is hardly relevant – and since when do we let China dictate our regulations or supervisory practices?

c) “This represents an inappropriate extension of government into private business decisions”. But there is little new here – at least since the 1930s, the relevant authorities have had the power to limit dangerous-risk taking by systemically important banks; the intent of the Dodd-Frank financial reform act was definitely to update and strengthen those powers. Banks are different from other businesses; their failure can jeopardize the entire economy – as we saw in 2008-09.

The banks will also worry that such pay restrictions will encourage their top talent to leave and join the relatively unregulated hedge fund and private equity sector. This is a legitimate point – and suggests that the pay reforms may actually be implemented. When powerful people (the hedge funds) want a change because it will disadvantage their competitors (the big banks), such changes are much more likely to happen in the American financial system.

Pushing risk-taking into hedge funds or other relatively unregulated entities does not of course solve the deeper problems that brought us to the brink of disaster in fall 2008. But attempts to develop a more comprehensive approach for the system – limiting size and leverage (debt relative to equity) for the biggest players – were defeated at the behest of the big banks.

Pay restrictions are not the ideal solution and they are not the end of the reform story. But we should take what we can get at this stage. Or, as seems more likely, we should encourage this debate to move into a more public arena – perhaps the regulators will push for restrictions and House Financial Services will raise objections.

The fight to make our financial system safer has barely begun.