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City Column: Unequal odds

27 Mar 08

Angus McCrone looks at how the City bonus system pushes brokers into risks that result in shareholders having to pay the price

by Angus McCrone

“He smiles to himself, saying that he has found that which the most skilful players have never discovered; that is, a roulette where he wins without paying, and is no loser when he loses.” That quote comes not from a report on the role of banking in the 2007-08 credit crunch, but from The Count Of Monte Cristo, written by Alexandre Dumas in 1846.

Then, the concept of asymmetrical incentives and risks was a neat but remote idea; in recent months, as banks have reeled from punch to punch, it has become a matter of political and public concern.

The problem highlighted by the financial upsets of the past year is that senior executives and star traders in banks are rewarded hugely when their risk-taking moves come off, but cannot be penalised to anything like that extent when they do not. So the incentive is clear – drive hard into complex, fast growing areas such as asset-backed securities, credit derivatives, and lending to private equity buyers and hedge funds. The harder they drive, the more money their banks – and they, via bonuses – make.

Probably. But if it does go wrong, which it may well do eventually, then the worst that can happen to the individual is the loss of their job, and the worst that can happen to the bank is a rescue by the authorities – because most banks of Northern Rock’s size or bigger are vital to the integrity of the financial system and therefore cannot be allowed to fail.

What is to be done, as Lenin would have said? In March, the Institute of International Finance, the association of global banks, felt the need to air ideas about how to address this problem of asymmetrical incentives on bankers’ pay. Ideas put forward included deferring bonuses for several years, and allowing banks to claw back paid bonuses if a strategy later comes unstuck.

There are snags. For instance, clawing back past bonuses would be likely to lead to a mountain of litigation between bank and offended employees or former employees. Deferring bonuses for several years might also lead to complex legal fights, since employees could argue that events outwith their control had led to the strategy failing.

However, politicians are coming under pressure to act. The sight of top executives walking away with vast pay packages during a crisis – as Merrill Lynch’s Stan O’Neal did last autumn with a reputed $160m, while his bank was writing off $7.9 billion on sub-prime loans – does not play well with voters.

One option would be to start with the regulation of the industry itself, giving the central bank the role of acting against credit and asset price excess during the cycle. Tightening policy at these moments could consist of tightening not just interest rates, but also levers such as reserve requirements and rules on maximum percentage mortgage loans.

On pay itself, if the value of bank executives’ bonuses depended on the long-term share price of the bank, it would turn those individuals into vigilant guardians of the interests of all shareholders. Not just vigilant, but a lot more knowledgeable about the pitfalls of lending, derivatives and trading than the average institutional shareholder.

This points us towards some sort of locked stock as a form of payment – shares that could not be sold for perhaps five, or even 10, years. However, if these were awarded with a single unlocking date, one executive might find that the moment his shares were unlocked was the middle of a boom and therefore end up with colossal gains; another might find that it was during a slump that had nothing to do with his own previous efforts. So the answer could be to pay high-flying executives and traders in shares that would become tradable in phases over five years. There would also have to be a rule to stop crafty executives using derivatives to hedge their profits on the locked shares ahead of time.

Problem solved? Well, not exactly – such a scheme could work if all significant banks could be corralled into signing up. That would require the commitment of the regulators not just in the European Union and North America, but in Switzerland, Japan, and the big emerging economies. Maybe pressure for reform after this credit crisis will be sufficient to force change on everyone.

Angus McCrone is a business journalist based in London

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