Sunday, November 22, 2009

Bankers' Pay Revisited

Yet again the debate on bankers’ bonuses has taken an ugly turn, with ostensibly sober commentators getting caught into the populist flow…

…Which is really too bad, as op-eds like this are a missed opportunity to inform the public about the fundamental problems in the financial sector (of which compensation is a by-product) and build support for policies to address them.

It’s in this latter spirit that I’ll raise here three key questions on bankers’ pay and hopefully offer some food for (constructive) thought/policy:

1. Are bankers paid too much, at the expense of their firms' shareholders? In other words, do bankers grab a bigger share of their firms’ profit pool than they are warranted by the objective of maximizing shareholder value?

2. Since taxpayers are called, now and then, to foot the bill of keeping one or more banks alive, should executive pay be so regulated as to control risk-taking by individual employees?

3. Are bankers paid too much…. full stop?

I’ll start with (2), which is the easiest to answer in my view: So.. I don’t think so. Or, at least, not beyond what the Fed’s recent proposal tries to achieve, which is to get bonuses to reflect the risks of employee activities, and to use longer periods for measuring performance for bonus purposes. But beyond this, preventing the next financial failure rests predominantly on improvements in firm-wide (and industry-wide) monitoring and management of risks.

The challenges here are vast: From developing better tools to measure risks more accurately; to appropriately monitoring risks across different business units (e.g. to avoid “balance sheet arbitrage”-type activities like those of AIG); to designing appropriate counter-cyclical capital requirement ratios... There is also a case (which I discussed here) for making financial institutions pay an insurance fee against future failures in the sector (à la FDIC deposit insurance fee).

Provided we can address these challenges, regulating executive pay is almost redundant as a tool to protect the taxpayer.

Then comes the question of whether bankers are paid too much at the expense of shareholder returns—by which I mean both absolute and risk-adjusted returns. One way to go about answering this question is to look at the volatility-adjusted excess returns (the Sharpe ratio) of financial firms vs. the market's.

My focus here is on "the stress-tests 19 ex-GMAC" rather than the entire financial sector, which includes small regional banks with no "bailout" and no “bonus issue”. I look at the period from November 1999 onwards, when the Glass-Steagall Act was repealed, though the results broadly hold for longer periods.

Turns out the majority of these institutions have outperformed the S&P 500, both in absolute and volatility-adjusted terms. Indeed some have done exceedingly well, with Sharpe ratios of four (JP Morgan, BofA) to 15 (Goldmans) times higher than that of the S&P500.

One eyecatching underperformer is Citi, which, provocatively, went on giving out fat bonuses as late as end-2007. The likes of SunTrust, Regions and KeyCorp have also trailed the S&P500. As simplistic this exercise is, it does suggest that, in many cases, the size of bankers’ salary pools has not at all compromised financial firms’ ability to reward their shareholders competitively.

One caveat of course is that realized volatility is only a partial measure of ex ante risk: Arguably, the government’s financial rescue helped avert a much more disastrous outcome than shareholders experienced. In other words, the “true” risk adjusted return was much lower ex ante, esp. if one were to include tail risks.

I buy that.. Still, a financial sector collapse would have probably meant a disaster for the entire economy and every firm in it, from retailers to car-makers to pharmaceuticals, due to the ensuing credit crunch. So it's uncertain how such an outcome would have affected relative performance.

Importantly, the implications for the level of executive pay are unclear: It’s not the level per se that is important for managing risk, but the structure of pay incentives. Even more critical is the ability of financial firms (and their regulators) to monitor risk at the firm/industry-wide level, as I argued earlier.

So then we come to the question of whether bankers are paid “too much…full stop.” The knee-jerk response of many an inhabitant of Main Street (“YES!”) is driven by the large wage differentials between finance professionals and employees in many other industries. These differentials are an empirical fact, even for workers with similar skills and even after correcting for “compensating factors” (e.g. unfavorable working conditions).

Literature offers a number of explanations: Different incentive conditions between sectors leading to different levels of efficiency wages; “unobserved abilities” by employees in highly-paid sectors; weak coordination of wage bargaining across sectors, leading to disparities in the share of industry rents going to employees; and variation in the profits of different sectors (allowing profitable industries to pay their workers more).

Here I’ll focus on the latter, because it is the most relevant for our “too much” discussion: If it is indeed large rents in the finance industry that drives bankers’ pay, could it be that financial institutions make too much profit?” Or, if you like, “Is there too little competition in the financial sector?”

Here is where things get tricky: Assessing the competitive environment in the financial sector is extremely difficult (see a nice discussion on this by Stijn Claessens here). Importantly, unlike many other industries, the “optimal” level of competition depends on balancing what are often competing objectives: The desire to improve access to financial services for a wide range of firms and households at low cost; foster product innovation; and ensure financial stability. The increasingly complex and evolving structure of financial institutions and the presence of scale economies and network issues complicate the task further.

This does not mean that policymakers should give up trying… on the contrary. In my view, a comprehensive assessment of the benefits and costs of the sector’s existing market structure, and the identification of measures to improve it (with both the stability and the access/efficiency objectives in mind) should be a top policy priority. Instead, what we’re getting these days are rash proposals to potentially limit banks’ size based on too-big-to-fail considerations, which completely miss the broader point of what is an “optimal” market structure.

Bottom line… Whatever the problems with bankers’ pay, they are the by-product of more fundamental problems in the financial sector as a whole: Inadequate risk-management and monitoring systems, unskilled (or complacent) and fragmented regulators and, possibly, a sub-optimal market structure.

So rather than going for the easy targets to appease a blood-thirsty audience, governments and journalists alike had better re-focus their efforts on policies that truly matter.

1 comment:

Anonymous said...

looks like goldmans shareholders do want a higher sharpe ratio!.. see here: