Bankers' pay

I have written in an earlier post and in other posts about how the incentive system at banks and investment banks needs to be overhauled if recurring financial crises are to be avoided.

The problem I have been highlighting is the heads-I-win-tails- the- firms- loses syndrome. Bankers rake in bonuses when they do well. When they run up losses, it is for the firm to pick up the pieces. At the most, bankers may lose their jobs and a portion of stock options that have not vested. But they would still have the accumulated bonuses of the past to enjoy life.

I have argued that only a portion of bonuses due should be paid out in a given year; the rest should be credited to an account in which there will be entries for bonuses for profits and negative bonuses for losses. At the end of, say, five years, the balance would be paid out to managers.

I note with satisfaction that my view finds endorsement from Raghuram Rajan, former Chief Economist of the IMF. Writing in the FT, Rajan says:

Compensation structures that reward managers annually for profits, but do not claw these rewards back when losses materialise, encourage the creation of fake alpha. Significant portions of compensation should be held in escrow to be paid only long after the activities that generated that compensation occur.

Rajan also makes the point that excess returns- that is, returns in excess of that warranted by a given level of risk- are rarely achieved. What a manager claims as excess return is actually a level of return for which the appropriate risk has not been factored in. Very often, the risk shows up much later in the form of a loss, not in the year in which performance is being measured. That's why a big chunk of bonuses must be deferred.