BANKERS are a funny lot. Most people blame them for the economic crisis that brought the world to its knees last year, yet some bankers in Britain are suing banks for €33m in unpaid bonuses - the biggest case of its kind in the UK.
These bankers seem unrepentant, and insist they deserve their bonuses. But to the man in the street the notion that any banker should receive a reward has become repugnant.
Even though many banks have returned to profitability, people argue that those institutions would have gone bust if it hadn't been for government bail-outs, and that the executives therefore deserve no prizes.
Most people believe bankers' massive bonuses contributed actively to the economic crisis. It's therefore not just revenge and envy behind the desire to restrain bankers' pay, but also a wish to prevent a similar crisis from happening in future.
Did bankers' bonuses and other financial rewards contribute meaningfully to the financial crisis? Should they be subject to strong curbs?
An article by Floyd Norris in the New York Times (NYT) earlier this year carried the headline: "It may be outrageous, but Wall Street pay didn't cause this crisis."
The article concentrated on rewards bank CEOs received in the form of equity in their own companies. It points out that they had a strong vested interest in ensuring their banks didn't go bust, as their shares and options would be worth nothing if that happened.
CEOs were also hit where it hurts
In fact, this is exactly what happened to Richard Fuld, the much-maligned former CEO of Lehman Brothers, which famously went bust just over a year ago. The value of Fuld's equity went from $1bn at the end of 2006 to zero.
However, the NYT article was written before international banks' shares rebounded and the holdings of executives with shares and options soared again.
An article in the Financial Times pointed out that these executives - whose fortunes run into hundreds of millions of dollars individually - owe a debt of gratitude to the taxpayer for bailing out their banks and thus allowing them to return to profitability. Share price rises have gone a long way towards mitigating these CEOs' pain.
Interestingly, the action planned by governments to curb executive pay doesn't hone in on existing shareholdings by chief executives and other senior management, and how these have responded positively to the market. Instead, the focus at the G20, and in countries such as the US and the UK, has been on cash bonuses and remuneration.
British Chancellor of the Exchequer Alistair Darling has said automatic bonuses for banking executives would be outlawed in an attempt to curb excessive risk-taking in the country's financial sector. At the same time, leaders of the G20 countries have agreed to limit executive bonuses, but didn't set specific caps.
Darling said bankers in Britain would in future be offered bonuses for their performance over several years, rather than for a single 12-month period.
Concurrent with these moves, international banking regulators have proposed harsher capital adequacy requirements for banks, and are supporting the idea that banks build up capital buffers in good times so that they have something to fall back on in bad times.
Risk should be properly regulated
Unpopular as it may be, I think striking at bankers' bonuses and pay is attacking the symptom and not the cause of the crisis. Its root cause was the fact that bankers' books didn't reflect - by far - the excessive risks they were taking.
Banks are supposed to keep more capital in reserve if they take big risks, thus making excessive risk-taking highly expensive. However, this didn't occur with subprime mortgages and the derivative products that were created based on these mortgages - crucially, because the risk was highly understated.
It's essential to note this point. The risks that banks were taking weren't made clear, not even to themselves. Effectively, it was a massive deception - a fraud, even.
The focus with banks should therefore be on forcing them to spell out risk, especially when it comes to derivatives. Crucially important is that regulators be able to spot the risk, especially if the banks have understated it.
And that's where the problem lies: with the regulators. The world needs regulators who are able to spot the risks that banks are taking. It needs banks to hold a solid cushion of capital against that risk. A side-effect of that would be that risky behaviour would be expensive, and the pay of excessive risk-takers would automatically be curbed.
Direct government action to curb bankers' pay and bonuses, though popular, is an unhelpful intervention in the market mechanism. The problem should be attacked by making it impossible for banks to understate risk.
- Fin24.com