11 December 2009

Megabankers Megabucks

How did it happen that a group of people have persuaded themselves that they should each be paid millions each year? How did they persuade their employers to pay in one year more than most of us can earn in a lifetime? Why did the non-executive directors or the remuneration committees or external regulators or the owners of the firms or the press not shout "Hold on; this can't be right"?

The proverbial Martian analysing earthling society would conclude that the work of bankers and "traders" must make the greatest contribution to human happiness and well being. Why else would we reward them so highly?

Not so long ago a bank's chief executive was paid about the same as a top civil servant or the CEO of any other public company. Since then, their remuneration has blasted off skyward dragging up the pay of other CEOs in its wake. Perhaps if we understood the mechanism by which this distortion arose we could throw the machine into reverse.

Employers didn't call a halt because it was the people in charge of the banks who were boosting their take home. Economists call this the agency problem - mangers running a company for their own benefit rather than the owners' benefit.

Non-executive directors didn't because they were taken in by the argument that pay had to be "competitive". Their responsibility was to look to the interest of the company on whose board they sat. The problem of pay inflation however was systemic. If other banks were paying more then the each bank had to up its offer to keep its best staff. As the old song says, they were only playing leapfrog.

The same problem affected remuneration committees who felt they had to pay more or the top talent would desert to a competitor. The committees were also made up of the same sort of people who were benefiting from the acceleration in top pay.

This is a perfect example of each doing what is individually rational but the outcome is collectively irrational, a kind of market failure. If no bank offered to inflate salaries, where would they desert to? (Actually they could have gone to private equity and hedge funds. Controlling them is another issue, but in my view there would be plenty of able people left to run the banks and in retrospect they couldn't have done a worse job.)

What about the banks' owners, the shareholders? If you held shares in one bank then you might be influenced by the competitiveness argument. Modern capitalism isn't like that. Most shares are held by institutions - pension funds, insurance companies and mutual funds - all of whom diversify their holdings and so can escape the narrow view. Sadly, institutions do not take their responsibilities as owners seriously. If they don't like what a company does they rarely put pressure on the board or raise issues at shareholders meetings. At best they quietly sell their holding. This is a major failing. Institutions look after the savings of people like you and me and should look after our interests.

Now would be a good time to cut bankers' pay. They are not in much of a position to move to a competitor or set up a new hedge fund. Government could do it - government should step in to deal with market failures. It would work best if governments acted together and so could resist banks' threats to relocate to less regulated environments.

Fund mangers could do it too, and probably more effectively. We should put pressure on fund managers to use their shareholdings to stop bankers helping themselves to the profits which would otherwise go to boost your pension, your life assurance policy, your ISA or other nest-egg investments.

So far the people running the investment institutions have got off lightly.

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