Prof. Reuven Brenner, McGill University
European Parliament has voted a legislation curbing executive pay for bankers. Is it a good way to address excessive risk taking in financial industry?
Reuven Brenner: No, it makes no sense. And the evidence is clear – and can be inferred from other experiments. First a broad example, then a financial one. Quebec is a good first example. As you know Canada has a national health care, unsurprisingly characterized by long waiting lines for doctors, procedures. Quebec government also decided that they must then determine how much physicians are paid and in distant villages be paid more than Montreal. The government decide where they must work – McGill medschool grads are not allowed to start practice in Montreal – unless they go to some assigned villages in the deep frozen North. Communism on a small scale – and you must be able to predict the consequences. McGill medical grads are leaving the province in droves – something people under communism wished to do, but could not. As a countermeasure Quebec kind of legislated recently (it is still a rather grey area) to allow small private clinics which are illegal elsewhere in Canada except Alberta. Still 1/3 of Montreal population now – 800,000 do not have a family doctor. You get access and speed up procedures in the same way as happened under communism: personal relationships and envelopes with cash. Take a look at the Oscar winning Quebec film, Barbarian Invasions – it wasn’t a satire, but a pretty accurate description of how 10 years ago the „system” worked. Now it is worse. This sequence will be similar if it is tried in banking. First governments subsidize then they believe they know how to then fix compensations and yet retain talent. Well, it does not work.
European legislators do not intend to regulate how much bankers are being paid. They want compensation to be structured differently to make it more related to performance of management. I realize how difficult it is to measure performance but idea to take a longer perspective seems quite reasonable, doesn’t it?
Well, how do government bureaucrats know anything about that? Under today universal banks you have „ordinary” bankers, investment bankers, traders and yes, hedge fund managers (in principle, if not by name). They require very different compensations – for example traders need shorter term bonus structure, because they have daily profit and loss. Governments have no idea how to tailor compensations for the different „bankers”. Actually one of Warren Buffet few failures was when, after buying Solomon and restoring its reputation and thus access to capital because some illegal acts done, that the top management knew about at the time, was when he realized that he had to reverse his compensation plans for Salomon. Whereas the principles were admirable, perhaps, God and Devil were in details, and the best traders and other bankers left the company. Though Buffet first said, good riddance, in 1995 he and the new CEO at the time, dropped the plan, because the company was sinking with key personnel leaving. Traders, investment bankers, hedge fund managers all need to be compensated differently. It’s one of the toughest issues to solve not only on Wall Street but in every company, every institution. Outsiders – even brilliant ones as Mr. Buffet – may not know how to do that. You may be brilliant in allocating capital – it does not imply you are brilliant in managing a financial company.
Does it really make so much difference if company pays 5 or 10 million to its CEO? There are not so many things you can buy for 10 million salary that you can not buy for 5 million.
A decent apartment in Manhattan, lets say 2-3 bedrooms in a nice place – but nothing extravagant is about 2-6 million, and living in London is as expensive too. Keep in mind that traders are at their desks by 04.00-05.00 am – because Europe is open etc. Same in London – where markets in the US stay open what for them is late in the night. So you have to live in proximity. And from that yearly salary you mention, in New York in particular 40% at least would be taxed away. Kindergartens are $10-20 K/year, schools $20-30K. I am not saying „Cry for them, Rest of the World” – but yes there is a big difference between 5 and 10 million. Second – the people who are paid these sums have alternatives at hedge funds. It is true that during the subprime there was an aberration because the top CEOs at Merrill, Bear Stearns, at banks turned out to be not exactly „bankers,” but more „marketers” – but that’s because banks turned from being in banking and doing due diligence about mortgages, to mere distributors of mortgages. That is now corrected. Also, traders have very short careers – by 36 they are burned out. If you were at a trading floor and saw how they work 12 hours before 6 Bloomberg screens – you can understand why. So it’s a bit like in sports – short career. As I said, compensation is probably one of the most difficult problem to solve in companies and institutions, even though the principles might seem obvious.
What will happen if the measure is implemented?
I think the European bankers would move elsewhere. Those are highly mobile people although not as mobile as doctors, because financiers need network of peers to operate more efficiently. They can move from London and Frankfurt to New York, Dubai, Singapore, Hong Kong. Or banks may find ways to circumvent curbs on salary. Laws about compensations are never so precise as to not be able to overcome by some contractual agreement. Lets say banks will spin off some activities, which do not fall under the definition of „banking” – where compensations not regulated, and „bankers” will have a stake in that spin off … in addition to salary etc. The solution to the problem of banking lies elsewhere – to separate deposit banking from everything else – which can be done, was already recommended about 150 years ago in the Peel Act for the first time. And have only deposit taking banking have access to the Fed. The others – would specialize in whatever they want – but would have no access. If for various reasons this simple – though perhaps drastic – solution is not feasible, then requiring various capital allocations is a more complex alternative – that’s the direction we seem to be going, though am not persuaded that it would not be sowing the seeds of new crisis. The principle should be to prevent infecting the payment system – and make it clear that only certain institutions have access to the central bank window and no others. Second, if in spite of the fact that this is done, the central bank in some unusual circumstances has to rescue – then the top management of the latter would know that it would walk away with nothing – as top management of bankrupt companies do.
interview conducted by Krzysztof Nędzyński
Reuven Brenner holds Repap Chair at Desautels Faculty of Management, McGill University. He is the author of among others “Force of Finance: The Triumph of Capital Markets” and “A World of Chance”.