Friday, January 18, 2008

Reining in bankers's incentives

Martin Wolf weighs in on the side of those believe that incentives in banking are flawed and need to be reined in:

By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks create gigantic incentives to disguise risk-taking as value-creation.

We would be better off with Jupiter’s 12-year “year”, since it takes about that long to know how profitable strategies have been. The point is that a year is an astronomical, not an economic, phenomenon (as it once was, when harvests were decisive). So we must ensure that a substantial part of pay is better aligned to the realities of the business: that is, is made in restricted stock redeemable over a run of years (ideally, as many as 10).

Yet individual institutions cannot change their systems of remuneration on their own, without losing talented staff to the competition. So regulators may have to step in. The idea of such official intervention is horrible, but the alternative of endlessly repeated crises is even worse.

.....all bonuses and a portion of salary for top managers should be paid in restricted stock, redeemable in instalments over, say, 10 years or, if regulators are feeling generous, five.

Yes, locking in rewards over a long period will help as will payment in stock. If rewards are to be in made in cash, only a portion of the rewards announced for a year should be paid out; the rest should be held back over the business cycle and adjusted for losses bankers' run up. When one bank poaches people from another, the vesting period of options assumed by the hiring bank should remain unchanged.

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