Sunday, February 15, 2009

Playing the bankers’ advocate…

Bankers are so vilified these days that “Banker” is at the brink of replacing “Economist” as a synonym for “Dismal”! Not that I’m jealous… I’d be more than happy to see economists passing on the baton of dismalness. But I’d rather see it go to a more deserving group!

On a more serious note, I feel the debate on executive pay is getting a bit out of hand, particularly when I see respected academics and commentators adopting the Michael Moore approach to op-ed writing. Certainly, news of bankers eating up taxpayer money while splurging on luxury jets hasn’t helped.

But adding fuel to the fire with populist indictments is not that constructive, if one wants to offer lessons for policy. So let’s take a look at a few of those:

1. “Brain” drain? Who cares? The argument goes that bankers contribute far less to this world than, say, surgeons... ergo pay restrictions would help shift “the best and brightest” towards more useful industries.

Well, I beg to disagree. The surgeon who will save me from dying is undoubtedly valuable. But, provided the industry functions properly, so is the banker who will help me secure a decent retirement once I survive the surgery; and so is that other banker who will choose to invest in the development of the cutting edge surgical equipment that my surgeon will use. And yes, I’d like to see (some of) the best and brightest making these decisions.

2. Bankers are overpaid: Before getting into the “over” prefix, let’s first explain "paid." Bankers’ pay is the cost that banks incur to employ one of the factors of production (labor)—the other being capital. Now, bankers could be overpaid under three scenarios:

(a) Aspiring bankers seeking a job have bargaining power over their employers, e.g. because only the "select few" can enter the job market. But this is not true. Anyone with access to higher education and a (pretty basic) grasp of quantitative methods can try “the banker’s path to success and personal fulfillment”, if they so choose. The sheer diversity of bankers’ backgrounds is the blatant proof, with the Harvard MBA sharing the same roof as the son of a Texan policeman and a math graduate from Bangalore.

(b) There are economic rents in the banking industry, which banks distribute in large part to their workers (e.g. in order to attract talent and foster productivity and loyalty). This argument may not be entirely off the mark. I welcome inputs by industrial economists here, but my understanding is that the US banking system is monopolistically competitive (e.g. see here). Which of course allows for rents.

But then the issue at stake has little to do with executive pay and far more with identifying an optimal structure for the industry—one that encourages competition and innovation without compromising prudential objectives.

Once that structure has been identified, executive pay should be left to settle on its own, as the by-product of this structure. The distribution of any resulting “rents” to bankers would only be harmful if (a) it were geared towards rewarding short-term performance (which has been part of the problem recently); or (b) if it amounted to “robbing” the owners of capital from their own share of the pie. Which brings us to our next point….

3. Did bankers "rob" the banks’ shareholders? Not exactly. Taking as a proxy for the sector's return on capital the total return on the stocks of financials, returns have tracked quite closely, or even exceeded, total returns in other sectors (I'll come to 2007-08 in a minute). In other words, bankers’ bonuses, even at their peak, did not undermine shareholders' returns. The caveat of course here is that shareholders failed spectacularly to see that those returns came with an unacceptably high leverage.

Coming to the 2007-08 debacle… Stock prices of financials were destroyed both in absolute terms and compared to other sectors! This called for drastic cost-cutting to preserve whatever shareholder value was left. And cost-cutting did occur. The industry shed 260,000 jobs within 12 months, bringing employment back to 2003 levels, with the obvious implications for the overall wage bill. And the bonus pool was down 45%.

Of course more could (and should) have been done. Still... the fact that bankers are losing their jobs by the buckets flies in the face of critics who claim that bankers take too much risk because they have too much upside and zero downside. In fact, let’s examine that argument in more detail…

4. Bankers take excessive risk because their downside is limited and, well… because they’re greedy!

OK, first of all, it’s the bankers’ job to take risk. We hire them to take risk, provided they can price it accurately and take an appropriate amount of it. Evidently, over the past several years a number of failures occurred and I won’t go into the “why’s”: Failures to price risk by the credit rating agencies; failures of bankers to conduct their own due diligence; failures of banks’ risk management units to raise the red flag; failures by the supervising agencies to evaluate the extent of systemic risk; and a Big Fat failure of ownership.

That’s right.. As I already pointed, shareholders failed to live up to the responsibilities that come with ownership, such as enforcing a system of checks and balances and a long-term vision for the firms they own. Instead they preferred to dance while the party was on. Mind you, not just the owners of banks. Everyone partied and nobody wanted to stop.

Given that environment, bankers—each on their own—behaved optimally: They took risk to maximize shareholder value and, in the process, enrich themselves, but not only. They also enriched the homeowners, the states’ tax coffers, the retailers, the automakers, the oil exporters, the Chinese…

Call that greedy, for sure. But so were many others, not least those homeowners who borrowed against their newfound home “equity” to splurge on a life of home improvements and imported electronic gadgets. Both were excesses and both were equally undeserved.

5. The rich are getting richer and the poor poorer. Ultimately, much of the popular dismay has to do with a perception of a growing and undeserved income inequality. I sympathize in principle—I can’t see how society is served best with anyone pocketing $25 million annually, whether their name is Dick Fuld or David Beckham.

But I hardly see this as an argument for restricting executive pay. You don’t want to stifle the hope of the Texan policeman’s son that he can “make” it in life, whatever you might think about his definition of “making it”.

But… you would hope that whoever makes that kind of money would display some humility, in appreciation of the society that allowed them to be who they are; and/or their luck of being born in the kind of environment that put them on a one-way street to success. At the very least, you would expect them to be sensible enough to resist a bonus in a year when the world crumbled along with them.

Those who opted instead for the private jets and the $35,000 commodes deserve our collective kick in the butt. But that’s not because they’re bankers. It’s because they are inadequate human beings.

I rest my case.


Anonymous said...

Part of the big fat failure of ownership comes by virtue of the fact the fund managers and pension fund managers, wield undue influence over corporate decisions including remuneration. The block votes are derived from stock that is paid for by their investors, who don't get a vote.

There is at least the appearance of a nepotistic clique within the corporate elite that results in senior executives in fund management waving through excessive remuneration for bankers, because guess who sits on their non executive board for remuneration.

Anonymous said...

Under (2), you say three scenarios, but only list two. Odd. What's the third?

Here is my guess. Another phenomenon that leads to bankers being overpaid (as they indisputably were for quite some time) is the difference in incentives and interests between a firm's employees and shareholders. Shareholders have serious structural problems supervising corporate management, and once corporate pay levels get out of control industrywide it is difficult for shareholders to rein them in at any individual firm (without seeming to signal that their firm is a poor investment, etc). So industrywide cost controls may well be justified to deal with this structural problem, at least in finance. (Industries that actually generate value rather than destroying it -- like software and biotech -- should not be treated this way of course.)