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.
October 23, 2009; 12:47 PM ET
Categories: Financial Regulation , Solutions
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