The Future of Banking Sector Compensation

In the aftermath of every 'boom and bust' that has occurred within the global financial system throughout history, policymakers and stakeholders have proposed and implemented financial reform as a means to prevent future financial failures. In many cases the lobby from the big investment banks is to strong, and many reform acts don't make it through congress. The ones that do like the Glass-Steagall Act end up being repealed, and therefore we end up with a financial system that is vulnerable. Thus, when it is exposed to free-market forces such as profligacy, irrational exuberance, and greed, it cracks at the seams, and if not rescued, it breaks down completely.

Nothing has exhibited this better than the recent financial crisis. There is a fair amount of rhetoric circulating at the moment surrounding financial reform, and reinstating the Glass-Steagall Act has been one such mention. Compensation has been another. These, as well as many other areas within the financial system need be to critically evaluated, and recommendations for reform reform put forward. If we are to stave off future financial crisis, it is imperative that all loopholes are blocked up, necessary regulation is implemented, and a healthy financial system is created as a result. Moreover, we must be careful not to over-regulate, as this could also be to the detriment of the system. Constrained capital markets are as good as price-fixing in closed economy.

The first opportunity for reform within the global financial system:

1. Compensation

Uninformed, ignorant people will immediately say, 'Yes! Bankers get paid too much!' This is not the issue. The issue relates to the current structure of compensation. We are currently faced with a principle-agent problem - Shareholders looking to pursue long-term growth strategies, while managers are gunning for short term gains. A simple solution would be to provide compensation that is paid out over a number of years, or has to be held in company stock over the 'long term'.

Unfortunately it runs a bit deeper than this, as Nouriel Roubini points out very concisely in his book Crisis Economics. Shareholders visions do not always run contrary to that of finance managers, and in many cases their interests very much align. Sometimes shareholders are happy for money managers to take risks, as a lot of the time their contribution to the pie is relatively small, and they don't have that much to lose when compared to the lenders. A complex problem is thus presented. How do we reform compensation so that all parties concerned are happy, and the new compensation structure remains fair? Roubini has some sound suggestions which are focused on the long term and vested interests:

Instead of forcing employees to hold company stock for a few years, they should be forced to hold compensation stock until their retirement.

Reward traders on performance averages over the long term, rather than for risky short-term bets they may have made.

Reward traders with a portion of instruments they are trading in. This may make them think twice about conjuring up some toxic-waste-multiple-tranche-asset-backed-security. Credit Suisse did this in 2008 with $5 billion worth of toxic assets, much to the disdain of some employees who played no part in creating these assets.

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