Sector talk: Top Bankers---Are they bankable?

In the last six months several leading international banks have acknowledged large losses due to their exposure to the US sub-prime market.

Some financial sector CEOs have been dumped for their poor performance, e.g. the heads of UBS, Citibank and Merrill-Lynch. However, this is scant comfort to the thousands of Citibank and Merrill-Lynch employees who are being laid off while their erstwhile CEOs, Chuck Prince and Stan O’Neal, were paid $50 million and $160 million, respectively, for being sacked! In 2007, the average annual income for top international private equity and hedge fund managers was about $500 million.

Except in the most extreme of cases, errant bankers lose their jobs but soon return to the job market. Obviously, it cannot be anybody’s case that bankers are flawed human beings! It is just that “rogue” trading is to be expected if there are no lasting personal consequences for betting the house with someone else’s money.

US banks and other well-known financial institutions have been periodically involved in high-risk activities, which have led to system-wide consequences. Central banks/governments are unable to tackle the moral hazard head-on and usually have no option but to enhance liquidity and/or provide financial support. Martin Wolf writing in the Financial Times pointed out that unbridled risk taking has a lot to do with the compensation incentives for bank management. The repetitive nature of these episodes, which are not always correlated with business cycle downturns, suggests that there is a tendency for bank management to look the other way if expected returns are considered to be high enough.

The potential for stratospheric bonuses induces investment bankers, including those involved with capital markets, to take higher financial risks than any other form of economic activity. For instance, compensation for fund managers is usually derived from a “2% plus 20%” formula. That is, 2% of the principal invested as service fees and 20% of the returns achieved above an agreed benchmark. Both numbers are usually higher for hedge funds.

Banks and other financial intermediaries add value by unbundling risk and parcelling bits out to those who are best able to carry the risk on their books. However, those who choose to retain substantial risk on their books should pick up warning signals in time. Systemic risk in the financial sector can extend to the real economy and hence the need to enforce discipline among market makers.

Several commentators have recently suggested that bankers should be paid their bonuses on an ex-post basis over a suitably long period such that the financial consequences of their decisions become apparent. This should dilute the motivation — get fabulously rich instantly — but it may be difficult to assign accountability if disasters were to surface years after the event. On balance, one way to suppress the most egregious kind of risk taking behaviour in financial markets could be to stagger and perhaps even cap annual bonuses.