Bankers' pay: agency and supply
I intended to mention this little tussle between Felix Salmon and John Carney a couple of weeks ago. As it happens, it's provoked an idea on a solution to the eternal problem of bankers' pay.
Carney points out that we don't actually want traders to take the minimum possible risk in all circumstances. If they did, they would never make any returns at all. Instead, we want them to take the right level of risk...at the scale of the whole economy, this is the socially optimal level; at the scale of an individual company, it's the optimal level of risk for shareholder value.
He says that without guaranteed bonuses, traders will take less risk than shareholders want them to, because they will need to retain some amount of guaranteed upside to pay their mortgages.
Felix's argument against this is interesting, because he doesn't quibble with the theory. As various people have pointed out, because shareholders have limited liability, they have an incentive to get their companies to run up large debts and gamble with them. Presumably they want their traders in turn to be incentivised to do this.
But Felix simply says that, in reality, this doesn't happen.
The fact is that guaranteed bonuses are a tool used by smaller, weaker banks who are desperately trying to beef up their trading desks to compete more effectively with the larger trading powerhouses. You don't hear much about Goldman Sachs or Citadel paying their traders guaranteed bonuses.
The interesting thing here is that it reverses the normal dynamics of employment...usually, a company is taking a risk by employing a new person whose skills are unproven. In this case, the employee is taking the risk by joining a bank whose ability to win business is unproven. Thus, they put the bank on a probationary period by demanding a guarantee.
Felix argues that the theory doesn't hold up in another way:
Riskier banks always trade on lower p/e multiples than boring banks which take very little risk. Invariably, when banks take on lots of risk, their employees get most of the upside while their shareholders wind up with the first loss.
It's slightly problematic to use p/e ratios here; riskier banks will have a higher return on equity, meaning that their earnings are higher and thus the denominator of the p/e ratio brings down the value. So this argument is not especially convincing.
But the second sentence does ring true: if there's a shortage of skills or employees in a sector, it's very plausible that employees will capture a high share of gross margins, reducing shareholder returns. This of course is one of the major features of trade unions and guilds - creating barriers to entry disproportionately increases wages for existing employees. While there are few trade unions active in the City, there are high barriers to entry - erected mainly by the existing employees of banks, in a classic principal-agent conflict - and this maintains the high returns to existing employees. Those high returns enable early exit for successful executives, which in turn reduces supply further.
Perhaps the best way to control the escalation of bankers' pay is not by regulation, but by a simple boost to supply. Bank shareholders should insist that their companies recruit 20% more new people each year. Perhaps the British and American Treasuries would even volunteer to subsidise this reduction in the graduate unemployment rolls, and at the same time increase the value of their accidental equity stakes in the major banks.