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Yes, bankers made money despite the crash

bankersgettingpaid.JPG

One of the louder arguments started by the financial crisis has been whether banker pay was a direct contributor to the crash. On the one hand, well, of course it was. Outsized risks generated outsized returns, and everyone loves outsized returns. On the other hand, of course it wasn't. These guys all had tons of stock in their companies and suffered huge losses in the crash. They might have taken bad risks, but they didn't have an incentive to do so.

In a new study, Lucian Bebchuk, Alma Cohen and Holger Spamann settle the empirical question of this debate: The bankers made more than they lost. Quite a bit more, in fact. Holdings get cashed out continually, if not entirely. What bankers made before the crash was a lot larger than the stock they held at the time of the crash. In the case of the top five earners at the top two banks, the difference was as much as $600 million. "Repeatedly cashing in large amounts of performance-based compensation based on short-term results," conclude the authors, "did provide perverse incentives ... to improve short-term results even at the cost of an excessive rise in the risk of large losses at some (uncertain) point in the future."

I think people get a bit off-track fetishizing banker pay, however. Even if the study had found that bankers roughly broke even between 2000 and 2009, it wouldn't be evidence that the trades were irrational. After all, most of the traders who went bust in the crash still have their jobs now that Wall Street is bouncing back. Their expected lifetime earnings aren't very different.

But if any of these guys had held back between 2003 and 2007, if their quarterly returns had been low year after year and they brushed off their angry bosses by arguing that this seemed sort of like a bubble, they would have been fired. Looking at the immediate financial incentives of bankers is a lot weaker than looking at the career incentives of bankers. As Keynes put it, "A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way with his fellows, so that no-one can really blame him."

Photo credit: Richard Drew/AP.

By Ezra Klein  |  December 10, 2009; 11:09 AM ET
Categories:  Financial Crisis  
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Comments

The only solution I can see is much higher marginal tax rates on bonuses and/or incomes over 250K. Clearly the banking industry is insulating itself from the downturn that they created. The best way to rob a bank is to own one.

Posted by: srw3 | December 10, 2009 12:00 PM | Report abuse

A couple of thoughts:

If bankers are making money by cashing out on short term bets, why not prevent this? Make them hold their bets for longer periods. Institute bonuses based on decade long averages instead of annual results.

Warren Buffet has described how if you want someone who invests well and can beat the market such a person will ignore what other people do. This makes sense because average people will run with the herd and get average results. We should make each individual responsible for choosing to run with the herd. We should also insulate them somewhat from bad luck by ... judging them on long term performance.

Posted by: bcbulger | December 10, 2009 1:25 PM | Report abuse

I'm not sure if we can force a ten year time horizon to calculate a banker's (I presume this means a trader's) bonus.

For starters, most bankers don't work in the same job for ten years, and for the most part not even the same bank for that length of time. So suppose you had a fixed income trader who made a killing for the bank in 2003-2006 being long credit, and then left the firm. Do you call him up in 2013 and tell him that the guy who took his spot maintained a long credit book into 2007-2008, and pay him nothing? Do you pay him when he leaves the firm (and thus incent everyone who has had a few hot years to leave and receive their payout)? Do you force people to stay at their firms for ten years?

Secondly, if traders don't get paid on their performance for ten years and I want the best traders for my prop desk, I pay top dollar in salary and no incentive comp, telling them their incentive to perform is 'not getting fired so you can keep that lush salary'.

I suppose you could tax pay above $250,000 or $1,000,000 at exorbitant rates, although in that event I think you'd either see lots of perks and/or most of Wall Street moving to London or other financial centers.

It's probably too radical to ever get anywhere, but I like narrow banking/limited purpose banking. Risk is kept at the level of individuals and partnerships with unlimited liability and clearly not too big to fail. Transition might be difficult too.

http://blogs.ft.com/economistsforum/2009/01/putting-an-end-to-financial-crises/

I'd also be in favor of fairly simple regulation which prevents any financial entity of a certain size from getting aggressive with leverage, in lieu of narrow banking.

Posted by: justin84 | December 10, 2009 4:22 PM | Report abuse

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