It is reported today that the highest earning employees of US banks in receipt of government aid will have their salaries slashed and remaining remuneration paid in stock that must be held for years. These are both ways in which the significant agency risks present in banks can be limited, but there is a major issue.
First, though, let’s revisit those agency issues. First, the higher the potential bonus that you pay a trader, the bigger the risks they are likely to take – the upside risk is that the trader gets a massive bonus, the downside risk is that he (or she) gets “only” a basic salary. The second issue is that if you pay bonus without a lock-in based performance over a short period, then there is an incentive to focus on short-term profits, ignoring in particular any longer-term risks incurred.
So isn’t it a good idea to limit pay to limit those risks? Only if the limitation is universal. If it is not, then there is a risk that the best employees will be poached by those banks that are not so constrained. All employees – including the best – prefer the prospect of more money sooner, so banks that are free to offer such benefits will poach these people. So in the case of the US, it might be risking the value of its (and the taxpayers’ ) shareholdings.
The banks who poach these high flyers are themselves taking a risk here – just because someone has produced good results in the past, it does not mean they will in the future. A high performer might have just been lucky, with their bets all working out in the past and large risks unrealised – but this is a risk that banks will be prepared to take.
There is also an issue that limiting bonuses does not cover, an issue that also contributes to bank instability. This is the payment of bonuses based on team performance. In this instance, there is an incentive to do the same as everyone else in the group. If you do well and you have acted independently, then your good performance might not make a huge impact on your bonus if team performance is a major factors; if you do badly and you have followed the team strategy, then you are unlikely to be singled out for the sack (although if the team has done badly enough, then you might need to go to the government for a bailout). This feature should be taken into account in any rules about bonuses.
But the key feature is that the rules about bonuses should be universal. If they only apply to some banks in a country, employees will move to other banks in that country; if they apply only to some countries, then employees will move abroad. Rules like these should come from the Basel Committee on Banking Supervision.