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A V Rajwade: Innovation and compensation


A V Rajwade  |  New Delhi 

Not only did the bankers earn a king’s ransom, the world continues to pay a heavy price for their innovation.

The other day, during the course of a presentation in Hyderabad about the turmoil in the global financial markets, one participant made a point about public sector and private banks: the former are bureaucratic, inward-looking but truthful; the latter more service-oriented, innovative, but you need to be careful about their marketing. The question was: which culture is “better” in the larger societal context?

There is no simple answer to that question. But the fact is that, with the mess in which the western banking system finds itself, there is a huge political backlash against the compensation structures of banks: these were justified, at least by the recipients, as just compensations for innovations and risk-taking. The latter, they claim, improve economic efficiency through better allocation of capital, and hence contribute to general societal good. The fact is that too many innovations are merely complexities aimed at hiding risks and making pricing less than transparent, and risks are taken at the cost of the share-holders, not the bankers themselves. No wonder, countries from Australia to Switzerland and even the US are either placing restrictions on bonuses, or are seriously debating the issue. Many senior bankers have decided to forego bonuses for the current year, and a few have even returned the money paid to them earlier. But, as a Financial Times editorial recently (November 29) argued: “Bankers’ bonuses must be regulated by more than guilt”.

Disproportionately high compensations in financial services is by no means a recent phenomenon. Keynes asked a long time back: “How long will it be necessary to pay City men so entirely out of proportion to what other servants of society commonly receive for performing social services not less useful or difficult?” The great man also said elsewhere something so relevant today: “Speculators … may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation”. But we need not go that far back for perspectives on the subject. In a highly prescient article in “Finance and Development” (September 2005, well before the current crisis) Raghuram Rajan argued that skewed incentives for investment managers may be adding to global financial risk. To quote, “The threat of ….extreme penalty, coupled with the limited upside from salaries that were not buoyed by stock or options compensation, combined to make (traditional) bankers extremely conservative.” He goes on to observe that “as traditional transactions become more liquid and amenable to being transacted in the market, banks are moving on to more illiquid transactions. Competition forces them to flirt continuously with the limits of illiquidity.” So true: as margins on vanilla transactions thinned, ever more complex derivatives had to be structured. To quote Dr Rajan again, “The kind of risks than can most easily be concealed, given the requirement of periodic reporting, are ‘tail’ risks — that is, risks that have a small probability of generating severe adverse consequences and offer generous compensation the rest of the time. (Another trait is) is to herd with other investment managers on investment choices, because herding provides insurance that the manager will not underperform his peers.”

The culture tempts the managers to take risks because, “First, there is typically less downside and more upside from generating investment returns, implying that these managers have the incentive to take more risk. Second, their performance relative to other peer managers matters, either because it’s directly embedded in their compensation, or because investors exit or enter funds on that basis. The knowledge that managers are being evaluated against others can induce superior performance, but also perverse behaviour of various kinds these developments are creating more financial–sector induced procyclicality than in the past. They may also create a greater (albeit still small) probability of a catastrophic meltdown.” How prophetic!

A recent book (Chain of Blame by Paul Muolo and Mathew Padilla) describes the sub-prime mortgage market in the US and how it developed in the last few years. According to the authors, the fast growth was driven by investment banks lending money to non-bank mortgage lenders to fund the mortgages, with the implicit assurance of buying them and securitising them. The business needed a chain of intermediaries from loan brokers who brought the business and earned up to 3 per cent commissions; the account executives responsible for growth of the business who earned bonuses; the “due diligence” performers; the lawyers and rating agencies; bond insurers; bond salesmen earning 1.25 per cent commissions, etc. “Innovations” for growth of the business included “stated income” loans (no proof of income needed); “teaser” interest rates for the first couple of years; salesmen dominating the poor compliance and credit assessment personnel; etc. This chain of middlemen did extremely well for a few years — the global economy is now paying for their excesses.  

First Published: Mon, December 22 2008. 00:00 IST