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Does banker pay matter?

There have been two arguments for limiting bankers' pay. One is that it's a way to punish executives at corporations that took a taxpayer bailout. The other is that it's a way to reduce the incentives for taking risks and is thus key to the new regulatory structure. I don't buy the latter argument. It misunderstands, I think, the nature of a banker's risk.

In his column today, Steve Pearlstein notes that "much of the damage during the recent bubble was done by traders and executives who had plenty of skin in the game and lost their jobs, their reputations and virtually all of their considerable fortunes when it all came crashing down. It's hard to argue they lacked sufficient incentives to be more careful with the risks they were taking."

Pearlstein is right about that. But the bigger risk for all these guys was in not making these trades when everyone else in the market was generating huge returns. As Henry Blodget has written, we need to be clear on "the difference between investment risk and career or business risk."

Professional fund managers are paid to manage money for their clients. Most managers succeed or fail based not on how much money they make or lose but on how much they make or lose relative to the market and other fund managers.

If the market goes up 20 percent and your Fidelity fund goes up only 10 percent, for example, you probably won’t call Fidelity and say, “Thank you.” Instead, you’ll probably call and say, “What am I paying you people for, anyway?” (Or at least that’s what a lot of investors do.) And if this performance continues for a while, you might eventually fire Fidelity and hire a new fund manager.

On the other hand, if your Fidelity fund declines in value but the market drops even more, you’ll probably stick with the fund for a while (“Hey, at least I didn’t lose as much as all those suckers in index funds”). That is, until the market drops so much that you can’t take it anymore and you sell everything, which is what a lot of people did in October, when the Dow plunged below 9,000.

In the money-management business, therefore, investment risk is the risk that your bets will cost your clients money. Career or business risk, meanwhile, is the risk that your bets will cost you or your firm money or clients.

The tension between investment risk and business risk often leads fund managers to make decisions that, to outsiders, seem bizarre. From the fund managers’ perspective, however, they’re perfectly rational.

A lot of the focus on pay caps proceeds from the assumption that traders are primarily motivated by the security of their fortune. But that's probably a secondary consideration behind the security of their job, which is, in turn, the main factor in the security of their future fortune. Any trader who tried to protect his bank account by hanging back from an irrational market would soon find himself out of a job and unable to get another. Conversely, a guy who loses a lot of money doing what everyone else did is probably still a highly paid trader after the market crashes. That's a much safer bet.

By Ezra Klein  |  October 23, 2009; 12:47 PM ET
Categories:  Financial Regulation , Solutions  
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Comments

The danger of wise individuals getting caught up in demonstration effects that actually turn out to constitute group madness is something we all need to guard against (ask any daily blogger, right?).

It comes down to the law, which is created from our cooler deliberations, expressly to constrain us when we get heated and lose our compass.

What this means is that a lot of market theory is too simplistic. Enlightened self-interest or even enlightened altruism, neither one can be counted on the way a good set of laws can. The finace industry cannot be left to chance.

In practical terms, we first need to envision what a responsible finance sector would act like, one indefinitely sustainable across the generations. Then we need to create laws forcing its players to conform to that model, in return for the franchise even to play.

Posted by: rosshunter | October 23, 2009 1:02 PM | Report abuse

Ezra, from your post:

In his column today, Steve Pearlstein notes that "much of the damage during the recent bubble was done by traders and executives who had plenty of skin in the game and lost their jobs, their reputations and virtually all of their considerable fortunes when it all came crashing down. It's hard to argue they lacked sufficient incentives to be more careful with the risks they were taking."

Pearlstein is right about that.

--

I haven't seen any evidence or statistics backing up this phenomenon that you are concurring with. Though the "much" qualifier leaves a pretty big opening for interpretation, I think Pearlstein's point (and your concurrence) is pretty clear - that MANY traders and executives lost virtually everything because of the market conflagration that they created and participated in.

Is this really true, though? Surely there are a few cases here and there, but, is it even a significant number?

I'd strongly argue that the "lost reputation" argument is laughable. I suspect that upon reflection, after reading your column since day one, that you also recognize that. Your post from earlier today underscores that point.

Additionally, doesn't this statement, "Conversely, a guy who loses a lot of money doing what everyone else did is probably still a highly paid trader after the market crashes ...", directly contradict your agreement (on that point) with Pearlstein?

And, as far as losing, "... virtually all of their considerable fortunes ...", if one were to lose $70 million of a $100 million investment portfolio accumulated over a 5 year period - ending up with $30 million - that being the downside, I think they'd take the same risk again in a heartbeat.

Just my opinion. I'd like to hear others.

Posted by: dresslar | October 23, 2009 1:23 PM | Report abuse

Did Angelo Mozilo lose his fortune? No, he took the money and ran.

The big losers in the financial crisis are highly visible, and they aren't bankers, they are home "owners". $8 trillion in nominal housing value had to disappear, for the banks to lose $2 trillion in mortgage value.

Casino finance is akin to the rigged games in a casion. The idea is to skim a lot of small players, with smart money doing well, the house taking its cut, and a few big losers on display to make it all seem legitimate.

The overcompensation of executives and money managers does indeed lead to excessive risk-taking, because it is structured in a way that encourages managers to construct ponzi-schemes that create the illusion of high-returns and low risk, for a few years (during which the managers pocket bonuses), with the risks realized only in the out-years -- the out-years happen to be now.

The essentially fraudulent nature of this scheme is revealed by the insistence that these managers also get big bonuses in the years of failure.

Much of banking and insurance is, or should be, low-risk, and is best run by boring civil servants, earning civil servant salaries, consistent with the low-returns of low-risk activity.

Letting an AIG put low-cost insurance for masses of people at risk, so that a handful of financial managers can skim hundreds of millions for themselves, by selling insurance for inadequate premiums, while either lying about, or simply miscalculating the risk is craziness. And, it is SYSTEMATIC craziness. (Which, I suppose, is your point.)

Pay caps make sense, if they make sense, as a way to change the system.

But, ultimately, the goal of changing the system, ought to be to reduce the cost imposed on a municipality borrowing for a sewer system, a family owning a home, or a poor schlub trying to cash his paycheck.

Because that's where these $100 million bonuses originate: some payday lender extracting 400% interest from some guy, who, in another era, would have had an account at a savings & loan.

Posted by: brucew07 | October 23, 2009 1:25 PM | Report abuse

The problem seems to be a desire to beat the market and avoid ever being beaten by the market. I think the first desire leads to cheating and the second leads to a herd mentality.

Perhaps these problems could be better managed by less focus on returns and more on the variance of those returns. Push the financial analysts toward a more steady, long term growth pattern.

Otherwise we will continue to have these companies selling garbage with large price tags and analysts running with the group long after Mr. Market has turned into a chump.

Posted by: bcbulger | October 23, 2009 2:28 PM | Report abuse

Brucew07 has it right here. What we need are more controls on what really amounts to usury and fraud (payday loans, excessive credit card interest, mortgage scams etc). And higher top marginal income tax rates (and an end to the preferential rate for dividends). That way the gov't at least gets back some of the cost of regulating these guys and the benefits to the less scrupulous aren't quite as great.

Posted by: Mimikatz | October 23, 2009 2:32 PM | Report abuse

If you say "you can only make so much money doing X" then someone will figure out you can do "Y" and avoid the pay cap. Then everyone will do "Y" even though "X" may be better for their clients. Is that really what you want?

The only way is to do it on the tax end. But we can't go there because everyone has etched into their brains the no new tax pledge whether they pledged or not.

But yes, that's the way to do it. Why does the $500 million the hedge fund manager makes get taxed at 15%? Would he really go Galt and get a job at a hot-dog stand if his take-home decreased from 425M to 300M?

If you properly regulate the front end and take the excess off the back end you leave the people free to make as much as they want in the middle.

Posted by: luko | October 23, 2009 2:33 PM | Report abuse

In a free market capitalist system, salaries are decided by a vote of the corporate directors, not one director.

Secondly, these life long career politicians, who wanted to SERVE the VOTERS, should be receiving the same weekly salary as the AVERAGE ANERICAN and NO MORE!

NOT these outrages salaries, pensions and expense accounts they currently receive at the taxpayers expense.

Posted by: peterclarke1 | October 23, 2009 3:07 PM | Report abuse

Ezra is exactly correct here.

I worked for several years on a fixed income trading desk, and the incentives are highly skewed.

Just one thing to add that's slightly different from his examples.

A retail investor might well be thrilled that even though he's lost money he's beating the market. However, in a bank setting you don't get any kudos for limiting losses. It doesn't matter whether you lose 5% or 10%, you're still a stupid #%$#, and you're roughly equally likely to lose your job (and definitely likely to not get a bonus). It's tough spinning negative performance up the chain of command. Saying 'well we lost 5%, but the market was down 20%' to the guy in the corner office who now has a lower bonus due to your losses never works - he just screams at you for being invested at all, as if there was a crystal ball that forecast every single dip in the markets. Since the market can correct at any time, it doesn't make a whole lot of sense to play it safe, since even the safe investments can go somewhat negative.

On the other hand, bonuses are proportional to earnings. Swinging for the fences is your best trade. The only additional downside of getting your face ripped off in the markets is reputational, since your job is probably already gone with the modest loss.

With my experience, I think the obvious answer to this problem is that publicly insured banks shouldn't have propreitary trading desks, but that's just me.

Posted by: justin84 | October 23, 2009 5:32 PM | Report abuse

--"Does banker pay matter?"--

Klein just can't help worrying about other people's money.

One of the beauties of a free economy is that any of the people finding fault with any particular business are free to try to crank up their own versions. Of course, that requires a certain amount of work.

One of the uglinesses of what the U.S. is becoming is the rise of a reactionary left whose first instinct is more boot on the neck (and who don't seem to have the first clue about business or economics, which is why they turn to government for everything, which shows they don't understand government, either.)

Posted by: msoja | October 23, 2009 5:33 PM | Report abuse

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