Will Banker Bonus Deferrals Help?

Regulators are in the midst of trying to develop new bonus compensation rules for banks. This will likely come to the delight of many Americans outside Wall Street, who gasp when they hear of the extraordinary lump sums taken home by bankers and traders each year. But these regulations aren't likely to limit the sizes of bonuses -- just how they're paid. One likely characteristic of the new arrangement will be to defer some payment to future years. Will it help?

Earlier this week, the Aaron Lucchetti and Sara Schaefer Munoz of the Wall Street Journal reported that regulators are close to deciding on new rules for bank bonuses. They're leaning in the direction of forcing banks to set aside some portion of bonus compensation for three years or more. But some details remain unresolved, such as what types of financial firms and employees would be subject to these deferrals, and how large a percentage of bonus pay must be deferred.

Why do some financial reformers favor deferred bonus compensation? In theory, there could be two benefits to economic stability.

Discourages Long-Term Risk Taking

First, some worry that annual bonuses encourage bankers to take long-term risk by seeking short-term profit. They point to financial products that blew up during the financial crisis as lucrative at first, but ultimately disastrous. If some portion of a bonus is deferred, then maybe bankers and traders will be more careful about the longer-term risk involved in their transactions, since their pay would also depend on performance of the trade in future years.

This sure sounds sensible, but would it really have made much difference in the recent economic crisis? It's hard to see how. The problem wasn't that Wall Street was simply focusing on short-term profit and ignoring the long-term consequences of their bets. The problem was that they vastly underestimated long-term risk. It wasn't just the bankers and traders involved in ill-fated transactions that lacked foresight -- everyone down the line was wrong. Management failed to stop these bad bets, risk evaluation groups signed off, rating agencies missed it, bond insurers failed, and shareholders nodded in unison as the profits poured in.

The only thing that deferred bonuses would have changed is that bankers and traders would have ultimately paid something for the losses that mostly got pushed to shareholders when bank stock tanked. So it doesn't seem likely that those on Wall Street would have behaved very differently. They believed these ill-fated transactions would work out in the long-run.

Hedging Bad Bets

And that sort of relates to the second theoretical benefit to deferring bonus compensation. Imagine if a bank has a big pool of deferred bonuses. Then an economic shock throws the market into disarray turning bad lots of bets taken by its bankers and trades. The deferred bonus pool will provide some cushion for those losses. But will that shock absorber be enough to prevent the bank's failure in a crisis situation?

While that cushion certainly would not have hurt banks, when panic sets in and bank runs begin, the several billion dollars of capital that these deferred bonus pools provide big banks with wouldn't be enough to restore confidence in the sector. A bet made by a bank can often result in a long-term loss bigger than the immediate profit it provides. During the financial crisis, there were numerous instances when private investors stepped in to provide banks with additional capital, but it didn't help. Investors began to relax only after the government decided to step in to backstop the banks.

Yet it does seem just that the bankers and traders responsible for transactions that result in losses should be the ones to absorb some of that impact through clawbacks. This rationale is pretty hard to argue against. If a transaction or trade's ultimate value is unknown, a profit shouldn't be realized until it is clear of risk. By providing annual bonuses, sometimes this very intuitive principle is violated. That's different, however, from saying that deferred bonuses pools could have prevented a financial crisis.

Not a Silver Bullet, But not a Bad Idea

So will deferred bonuses result in everlasting financial stability? If the most recent crisis is considered, then they probably won't prevent serious crises. But from a risk-reward fairness standpoint, it's hard to deny the concept of rewarding based on the ultimate return of a bet instead of the immediate or even expected return.

The important thing is that there's sufficient international coordination when it comes to compensation rules like this. Europe has already created similar rules, and some European banks are threatening to move their headquarters as a result. But if these rules are the same everywhere, then there would be no escape. So assuming such coordination, although bonus deferrals might not help, they probably couldn't hurt.