Finance & Development, March 2010, Volume 47, Number 1

Steven N. Kaplan

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BANKERS’ bonus season has arrived. This year opposition is stronger than ever given the number of high-paying firms bailed out with taxpayer dollars during the crisis. So why should bankers get their bonuses?

Opponents of bonuses make three arguments. First, bankers are overpaid, particularly given the hardships Main Street faces. Second, bonuses are undeserved because many banks would have earned less or failed to survive without government intervention. Third, large bonuses encouraged bank executives to take excessive risks, contributing greatly to the financial crisis. The anger is understandable, but none of these arguments stands up to scrutiny.

Bankers are well paid, but their high pay is not unique. Pay has increased markedly over the past 30 years for many—investment bankers, investors (hedge fund, private equity, and public money managers), top corporate executives, consultants, entertainers, top athletes, and lawyers. Changes in technology, scale, and globalization have allowed these professionals to leverage their skills. Top investors can now manage far more money than they could three decades ago, bankers and lawyers work on larger deals, and top professional athletes reach larger audiences. Whether fair or moral, their high pay is largely market driven as companies compete for talent.

Deserving bankers

Some critics claim bankers would have no alternative if they were not paid as they are, or did not receive the bonuses they do. The critics are naïve. The best bankers have other options. Star deal makers can go to boutique investment houses and hedge funds or become nonbank money managers. Many already have. A top Citigroup trader, Matthew Carpenter, left in early February for hedge fund Moore Capital, following in the footsteps of another top trader, Andrew Hall.

The greater the reduction in, and restrictions on, pay at large banks, the greater will be the exodus of top talent over time. Some might applaud such a development, but it would weaken the largest financial institutions. The government bailout (and continued subsidization) of some banks does not change banks’ need to pay market prices for their talent or risk losing it. The public also is hurt by a less-well-managed banking system (consider the problems pay issues have created for AIG, Fannie Mae, and Freddie Mac).

True, some portion of bank profits this year is a result of government intervention, but the banks paid for that intervention. Most have now repaid the Troubled Asset Relief Program (TARP) money received from the government, and the United States has profited from the “investments.” Those who think the return is not enough should criticize the U.S. government for cutting a bad deal rather than the bankers for doing their jobs and making money.

Some banks were effectively forced to take TARP money. They are now being asked to hurt their business and employees (by not paying bonuses) after repaying the government money they did not want or need.

Professional sports provide a good analogy. Say a soccer team has a terrible year because its star goalie had a bad season. But its star forward led the league in scoring. Does this mean the team should not pay the forward generously to ensure he stays with the team? And, if the team has a fantastic season the following year, does that mean players should not be paid because of the bad record the year before? Of course not. Such practices would be detrimental, if not suicidal.

Beyond the bonus furor

Large bonuses were not a primary cause of the financial crisis. Bear Stearns and Lehman Brothers were more aggressive than their peers in encouraging employees to defer bonuses or invest them in company stock rather than take cash up front. Stock ownership and bonus deferral did not save those firms. Bank executives lost hundreds of millions of dollars on the stock they owned because of bad decisions they made. Many lost their jobs.

Rather, the crisis was caused by loose monetary policy, a global capital glut, excessively leveraged investment banks, mandates from Congress to provide mortgages to people unable to afford them, flawed ratings from the rating agencies, and up-front incentives for mortgage brokers. Consistent with this, the crisis spread to financial institutions in many countries with very different pay practices.

Instead of fixating on compensation and bonuses, critics should focus on more sensible capital requirements. An effective solution would impose higher and procyclical equity capital requirements on banks, combined with a requirement to raise contingent long-term debt—debt that converts into equity in a crisis. These debt investors, not the government, would have bailed out the banks. The financial crisis would have been substantially smaller, if it had occurred at all.

The anger toward bankers is understandable, but eliminating or restricting their bonuses will damage the financial sector while doing little to stop any future financial crisis.