Monday, December 14, 2009

Fixing the banker bonus problem

After having forced governments all over the world to take extraordinary measures to prevent a complete collapse of the financial system, bankers continue to behave as if nothing has happened. The squeals of outrage over the imposition of taxes on bonuses in the UK is symptomatic of a group of people who simply don’t get it.

Or do they? Are they just behaving predictably given the way their industry is currently organized? Is there a way to change that behaviour without resorting to demonizing the whole profession?

The modern investment banking business has a lot of parallels with professional sports. Bear with me here, because the question of how to rein in banker’s bad behavior and out-sized compensation has already been solved in professional sports. By applying some of the same analysis to banking, it is possible to come up with a solution.

If you consider the professional sports leagues, there is an interesting mix of government, ownership, and “talent”. The ownership is either private or public, but in all cases participates in what is a zero sum game – there is a limited amount of talent, and bidding for that talent with higher salaries and bonuses eventually destroys the business that employs the very talent being sought.

The cost of stadiums is so high, that governments, typically in the form of a city or state, are bullied into supporting construction costs under the dubious presumption that the team brings some sort of benefits to the community. Taxpayers are ultimately on the hook for borrowings which are typically financed against municipal or state tax revenues.

Having implicated the government into their business, the owners then face the “talent” who act as individuals seeking to maximize their income. There is no real loyalty between the talent and the employer, just a contractual relationship. In order to avoid ruinous bidding wars, most professional sports leagues have imposed salary caps and income re-distribution mechanisms to ensure that balance is retained between the competitors.

Now let’s look at banking. There is a limited pool of talent seeking to maximize individual income. There is no loyalty to the institution providing employment. The banks are so important to the community that governments regulate and support them through many different mechanisms, with taxpayers ultimately bearing the risk. The only things missing are the salary cap, and apparently, the common sense to realize what is going on.

The loser in the whole banking game today, apart from the taxpayer, is the shareholder. There is no discussion about the proper share of profits between the shareholder and the talent, because the management of the banks ARE the talent. They have no incentive to behave themselves or to protect the shareholders, because they are enriching themselves in the “stadium” provided by the shareholders and taxpayers.

Since there are no banking leagues to bring order, or realistic ways to impose salary caps (since they have to be global to be effective), a much simpler and more effective measure would be to limit total compensation to talent as a percentage of profits. The majority of the profits should go to shareholders who take all the risks (taxpayers should be compensated through profit tax). By insisting that talent get paid after tax and shareholders, and that shareholders should get the bulk of the profits, the talent bonus pool becomes a realistic reflection of the real surplus after expenses, taxes, and risk reserves.

Since bankers have demonstrated the ability to thrive under all conditions, they will certainly figure out mechanisms for distributing the remainder to themselves as inequitably as they do now, but that is the talent’s problem.

Singapore has a great opportunity to take the lead in this area. It has demonstrated the benefits of a simple and relatively flat income tax regime, now it can take the lead in solving a problem that is vexing the rest of the world.

And since I am not a banker (ever again), I offer the solution up without royalty payments being required.

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