Bank Bonus Reform Isn't Affecting Risk-Taking

Back when the financial crisis hit, bank bonuses were often criticized. Some lawmakers argued Wall Street's compensation culture resulted in bankers and traders taking bigger long-term risks that didn't manifest themselves until after they were paid big bonuses based on short-term profit. But reform is proving difficult and might not even be effective.

You might recall that the massive Dodd-Frank financial regulation bill actually had very little to say about bonuses. Instead, the Federal Reserve intends to set some new guidelines, which will result in longer-term compensation plans that allow banks to claw back bonuses if losses are incurred years after bonuses are awarded. But an article from Bloomberg today reports that global banks have been slow to institute such new compensation structures. What's the problem?

Obviously, bankers and traders aren't crazy about new ways to defer their pay -- and they're the ones with the leverage. If one bank tells a key trader that her bonuses will be deferred for five years going forward, she won't be pleased. She'll probably start shopping around for a new job; after all, she can trade from anywhere. If all the other banks are acting in unison, then that's fine -- she'll just start a hedge fund.

Moreover, Bloomberg quotes a European analyst who says that such compensation changes probably won't help much anyway:

Limits on cash bonuses and "timelines of payouts in themselves do little to curb individual incentives for excessive risk-taking though they are steps in the right direction," said Sony Kapoor, managing director of policy think-tank Re-Define Europe.

In fact, the financial crisis is really proof of that. Even before it caused calls for deferred compensation, bankers typically received a large portion of their pay in stock that might not vest for some time. And even after it did vest, they often held onto a lot of their firm's stock. That's why there were a significant number of Bear Sterns and Lehman executives who lost a great deal of money when the companies' stock collapsed as the firms faltered.

The financial crisis wasn't just a matter of bankers not worrying enough about long-term risk. It was a case where they didn't anticipate the risk. That's why so many held onto the stock of firms that ultimately failed.

Moreover, even if deferred compensation techniques are in place, risk-taking won't change much. Bankers have to take risk in order to maximize their profit. There's risk in every choice they make. They believe that these risks are calculated to be reasonable and will ultimately pay off. But they will always have imperfect crystal balls, so the distant future will continue to hold unanticipated economic shocks that will lead to some bad bets. That isn't to say that some compensation reform wouldn't help a little, just that it isn't a silver bullet.