Banks and Compensation

I have argued on this blog before that the financial crisis was caused primarily by regulators who slept on the job in addition to the idea that government will not let some banks to fail. I am less convinced that the remuneration that firms choose to pay their employees should concern anyone other than shareholders. In the last week, there has been confirmation that Goldman Sachs and JP Morgan, both investment banks, are back to high profitability and are prepared to pay bonuses and perks that are no different from the behavior that their critics loath.

I have little sympathy for the argument that such high pay is harmful to the financial system because it does increase the propensity for reckless risk taking. To my mind, the reason for high profitability in an industry is because of a unique ability or insufficient competition. That both JP Morgan and Goldman Sachs are making profits that are considered too high should lead to proper diagnosis of the problem. First, that many financial services firms and investment banks needed cash from government means that their managers are certainly not as bright as they believe. Secondly, it is possible that the distribution of profits favours a few firms in that industry and this to me makes more sense.

As Graham Bowley of the NYT states here, the recent crisis nearly decimated a large number of firms and that has allowed JP Morgan and Goldman Sachs to become the preeminent bakers for the moment. It is not clear that they will maintain this position but the fact that the crisis has led to a new industry with new opportunities exploited by the two shows that the markets are working decently. That these firms were propped up with public funds does not bother me much now because they have paid back. More competition is always better and regulatory policy should concentrate on this side of the business.

However, the possibility of a new crisis that devastates the market and leads to a widespread economic crisis still exists. So while governments are unhappy with the new bonus plans, I have little respect for this view. All they need to state categorically is that there will be no future bailouts irrespective of the cause and leave investment banks to their devices. Reigning in poorly designed incentive schemes in banks is the work of shareholders.