Posted in the Wall Street Journal:
Meetings like the G-20 summit this week in Pittsburgh aren't famous for their accomplishments, but this one bids to be different in at least one area: Cementing the notion that banker paychecks were the financial weapons of mass destruction that blew up the markets last year.
In most of Europe, the notion that "bank pay did it" is now settled truth. Nicolas Sarkozy wants a pay czar to set compensation levels at French banks. Angela Merkel, up for re-election this weekend, is campaigning against banker bonuses. The Federal Reserve is now joining the act with a proposal to regulate pay structures as a way to police safety and soundness and contain systemic risk. The Fed's idea, which doesn't propose to cap pay, is perhaps the least damaging, although it still sets a terrible precedent and makes more comprehensive wage and price controls in the future a difference of degree, not kind.
Governments can't get incentives right most of the time in their own policies. So the idea that regulators can better align banker incentives than a competitive marketplace fails the laugh test. What's more, the evidence does not show that bonus incentives caused the late, unlamented credit mania. It is certainly true that bankers (like most human beings) prefer higher bonuses, and that bankers made risky bets on which they booked big fees. But the reality of this mania-turned-panic is how widespread the excesses were, across big banks and small, foreign banks and domestic. The companies that fared relatively better paid huge bonuses too, but they had better risk management controls.
Bankers who owned large equity stakes in their banks—and therefore had a strong incentive not to see them fail—also did not outperform their peers in the crisis. And as Jeff Friedman of Critical Review notes, banks on the whole bought AAA- and AA-rated securities almost exclusively for their own portfolios. Thus they sacrificed the higher yields of the lower-rated tranches for the perceived safety of a AAA seal of approval—hardly the behavior of people seeking short-term gain, whatever the long-term consequences.
Far more important than bonuses were the incentives to issue and take on debt, especially housing-related debt, created by . . . the politicians who now want to blame banker pay. There's the systemic risk that the Federal Reserve created with the ultralow interest rates that subsidized credit for so much of this decade; the privileged status bestowed upon the ratings agencies by the SEC and others; and regulatory capital rules that favored securitized mortgages over the same loans when held in portfolio by the banks. True reform would grapple with these issues, rather than the calculated distraction of bank pay.
Going forward, the biggest systemic risk is the emerging reality that the politicians consider our biggest financial institutions too big to fail. This is a much greater incentive to excessive risk-taking than any bonus pool because it means the bankers get the profits while taxpayers absorb the risk of failure.
Bankers themselves know this as well as anyone, which may explain why the likes of Vikram Pandit (Citigroup) and Lloyd Blankfein (Goldman Sachs) have lately been paying lip service to pay controls. The real money maker now for the too-big-to-fail banks is the subsidy they get from the implicit and explicit government guarantees they enjoy. If these CEOs bow before the political class's pay obsessions, then the pols might let them keep this subsidy.
Too big to fail also masks the market signals that might warn about the risks of getting too big. Fannie Mae and Freddie Mac are now black holes for taxpayer money because government guarantees juiced demand for their debt and allowed them to grow almost without bound. Even multibillion-dollar accounting scandals didn't quell demand for their debt or equity because investors were confident the government would never let them default. A private debt issuer receives vital information about market perceptions of the risks it's taking on from the prices it pays for incremental capital.
If the political class wants to do something about banker pay, it could help normalize profits by addressing the ways that governments subsidize those profits through regulation, deposit guarantees and barriers to entry. But that's so much harder than denouncing bonuses.