Quid Pro Quo

No sooner has fear of an imminent systemic collapse of the financial sector subsided and banks receiving emergency funds to weather the financial turbulence are in a position to return the assistance to the Treasury, than "outsize" bonuses seem to be back at many banks.

Should we be bothered?  Is there a case for regulating compensation in banks and similar financial institutions?

At first blush, given our laissez faire beliefs, we would say no.  Let the market work.  Shouldn't banks be free to determine compensation practices as they see fit, as firms in other industries, such as say retail or manufacturing?

This has become an interesting and important question.  This was among the most prominent topics of discussion at last week's G-20 meeting of finance ministers from the world's most powerful economies.

The first step in the argument for regulation of bonus-pay at banks is the belief that the promise of outsize (often multi-million dollar) bonuses at financial firms provided incentives for taking outsize risks.  The second step is to understand that excessive risk taking by financial firms can be problematic because the financial sector is tightly interlinked via interbank loans and other financial flows.  A string of gambles gone awry at one firm has the potential to jeopardize the entire financial sector and, turn affect the functioning of the  "real" economy.  Because finance is such an important ingredient to the smooth functioning of a modern market economy, concern over the devastating consequences of such a chain-reaction, once set in motion, prompted the kind of intervention and rescue of banks that we saw earlier in the year.  In other words, because the financial sector is at the core of the economy, we cannot afford to let the financial sector collapse.  In economics this kind of a situation is referred to as negative externalities or spillovers.  So while we all share in the costs if the financial sector experiences turmoil, when the financial sector does well, the bonuses are awarded to the select few.  You could say that the costs are socialized, but the benefits are privatized.

Another important issue in this context is the fact that the bonuses are often based on relatively short-term performance criteria, but the negative spillovers may come to pass only when the system is under extreme stress, something that takes a while to build up, and happens relatively infrequently.  A large lag between the quid and the quo, you could say.

This is the sort of reasoning behind the discussion at the G-20 meeting.  So far it appears they haven't been able to agree on how to regulate banker pay (BBC news article here).  However, requiring higher capital reserve requirements  for banks, which would provide a thicker cushion against unexpected financial shocks, seems to have broad consensus.