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1. Big Bad Bonuses?
AFTER THE CRISIS
Should Bankers Get Their Bonuses? Bonuses and the “Doom Cycle”
Steven N. Kaplan Simon Johnson
B B
ankers’ bonus season has arrived. This year op- criticize the U.s. government for cutting a bad deal rather ankers’ bonuses are a high-profile symptom of a The real danger is that as this cycle continues, the scale of
position is stronger than ever given the number than the bankers for doing their jobs and making money. much larger and deeper problem—the ability and the problem is getting bigger. If each cycle requires greater
of high-paying firms bailed out with taxpayer some banks were effectively forced to take TarP money. willingness of the largest players in our financial and greater public intervention, we will surely eventually
dollars during the crisis. so why should bankers They are now being asked to hurt their business and system to take reckless risks. collapse.
get their bonuses? employees (by not paying bonuses) after repaying the gov- We have let a “doomsday cycle” take over our economic The best route to creating a safer system includes very large
Opponents of bonuses make three arguments. First, ernment money they did not want or need. system. (andrew Haldane, of the Bank of england, has iden- and robust capital requirements, which are legislated and
bankers are overpaid, particularly given the hardships Main Professional sports provide a good analogy. say a soccer tified a similar “doom loop.”) This cycle has several distinct difficult to circumvent or revise. If we triple core capital at
street faces. second, bonuses are undeserved because many team has a terrible year because its star goalie had a bad stages. at the start, creditors and depositors provide banks major banks to 15 to 25 percent of assets—putting capital-
banks would have earned less or failed to survive without season. But its star forward led the league in scoring. Does with cheap funding. If things go very wrong, they expect asset ratios back where they were in the United states before
government intervention. Third, large bonuses encouraged this mean the team should not pay the forward generously central banks and fiscal authorities will bail them out. the formation of the Federal reserve in 1913—and err on the
bank executives to take excessive risks, contributing greatly to ensure he stays with the team? and, if the team has a Banks such as Citigroup and Goldman sachs—and many side of requiring too much capital for derivatives and other
to the financial crisis. The anger is understandable, but fantastic season the following year, does that mean play- others in this past cycle—used the funds to take large risks, complicated financial structures, we will create a much safer
none of these arguments stands up to scrutiny. ers should not be paid because of the bad record the year providing dividends to shareholders and bonuses to man- system with less scope for gaming the rules.
Bankers are well paid, but their high pay is not unique. before? Of course not. such practices would be detrimen- agement and staff. Through direct subsidies (such as deposit
Pay has increased markedly over the past 30 years for tal, if not suicidal. insurance) and indirect support (such as the prospect of Less likely to gamble
many—investment bankers, investors (hedge fund, pri- central bank bailouts), we encourage our banking system to Once shareholders have a serious amount of funds at risk, rel-
vate equity, and public money managers), top corporate Beyond the bonus furor ignore large, socially harmful “tail risks”—risks that involve ative to the winnings they would make from gambling, they
executives, consultants, entertainers, top athletes, and Large bonuses were not a primary cause of the financial a small chance of calamitous collapse. Banks can walk away will be less likely to gamble and are more likely to keep dan-
lawyers. Changes in technology, scale, and globalization crisis. Bear stearns and Lehman Brothers were more ag- and let the state clean up. some bankers and policymakers gerous compensation schemes under control. This will make
have allowed these professionals to leverage their skills. gressive than their peers in encouraging employees to defer even do well during the collapse they helped to create. the job of regulators far easier and give our current regulatory
Top investors can now manage far more money than bonuses or invest them in company stock rather than take system a chance to work.
they could three decades ago, bankers and lawyers work cash up front. stock ownership and bonus deferral did not Mind-boggling failure We also need to ensure that individuals who are part of any
on larger deals, and top professional athletes reach larger save those firms. Bank executives lost hundreds of millions regulators and supervisors are supposed to prevent this dan- failed system expect large losses when their gambles fail and
audiences. Whether fair or moral, their high pay is largely of dollars on the stock they owned because of bad decisions gerous risk taking. But banks wield substantial political and public money is required to bail out the system. even though
market driven as companies compete for talent. they made. Many lost their jobs. financial power, and the system has become remarkably com- many executives at bailed-out institutions lost large amounts
rather, the crisis was caused by loose monetary policy, a plex, so eventually regulators become compromised. The ex- of money, they remain very wealthy.
Deserving bankers global capital glut, excessively leveraged investment banks, tent of regulatory failure ahead of the current crisis is mind- Other bankers obviously won big from the crisis. U.k.
some critics claim bankers would have no alternative if they mandates from Congress to provide mortgages to people boggling. Prominent banks, including northern rock in the Chancellor alistair Darling appointed Win Bischoff, a top
were not paid as they are, or did not receive the bonuses they unable to afford them, flawed ratings from the rating United kingdom, Lehman Brothers in the United states, and executive at Citigroup in the run-up to its spectacular failure,
do. The critics are naïve. The best bankers have other options. agencies, and up-front incentives for mortgage brokers. Deutsche Bank in Germany, convinced regulators that they to be chairman of Lloyds. Vikram Pandit sold his hedge fund
star deal makers can go to boutique investment houses and Consistent with this, the crisis spread to financial institu- could hold small amounts of capital against large and risky to Citigroup, which then wrote off most of the cost as a loss;
hedge funds or become nonbank money managers. Many tions in many countries with very different pay practices. asset portfolios. The whole banking system built up many nevertheless, Pandit was soon named Citigroup CeO. Jamie
already have. a top Citigroup trader, Matthew Carpenter, Instead of fixating on compensation and bonuses, crit- trillions of dollars in exposures to derivatives. This meant that Dimon and Lloyd Blankfein, CeOs at JPMorgan Chase & Co.
left in early February for hedge fund Moore Capital, follow- ics should focus on more sensible capital requirements. when one large bank or quasi bank failed, it was able to bring and Goldman sachs, respectively, are outright winners, even
ing in the footsteps of another top trader, andrew Hall. an effective solution would impose higher and procycli- down the whole system. though each of their banks also received federal bailouts and
The greater the reduction in, and restrictions on, pay cal equity capital requirements on banks, combined with Given the inability of our political and social systems to han- they agreed to limit their bonuses for 2009. Goldman sachs
at large banks, the greater will be the exodus of top talent a requirement to raise contingent long-term debt—debt dle the hardship that would follow economic collapse, we rely was lucky to gain access to the Fed’s “discount window,” so
over time. some might applaud such a development, but it that converts into equity in a crisis. These debt investors, on our central banks to cut interest rates and direct credits to averting potential collapse.
would weaken the largest financial institutions. The govern- not the government, would have bailed out the banks. The save the loss makers. While the faces change, each central bank We must stop sending the message to our bankers that they
ment bailout (and continued subsidization) of some banks financial crisis would have been substantially smaller, if it and government operates similarly. This time, it was Federal can win big on the rise and also survive (or do well finan-
does not change banks’ need to pay market prices for their had occurred at all. reserve Board Chairman Ben Bernanke and Treasury secretary cially) on the downside. This requires legislation that recoups
talent or risk losing it. The public also is hurt by a less-well- The anger toward bankers is understandable, but Tim Geithner (president of the new York Federal reserve Bank past earnings and bonuses from employees of banks that
managed banking system (consider the problems pay issues eliminating or restricting their bonuses will damage the in the run-up to the crisis) who oversaw policy as the bubble require bailouts. n
have created for aIG, Fannie Mae, and Freddie Mac). financial sector while doing little to stop any future finan- was inflating—and are now designing our “rescue.”
True, some portion of bank profits this year is a result cial crisis. n When the bailout is done, we start all over again. This has Simon Johnson is a professor at the Massachusetts Institute
of government intervention, but the banks paid for that been the pattern in many developed countries since the mid- of Technology’s Sloan School of Management, a senior fellow
intervention. Most have now repaid the Troubled asset Steven N. Kaplan is Neubauer Family Professor of 1970s—a date that coincides with significant macroeconomic at the Peterson Institute for International Economics, and a
relief Program (TarP) money received from the govern- Entrepreneurship and Finance at the University of Chicago and regulatory change, including the end of the Bretton Woods member of the Congressional Budget Office’s Panel of Economic
ment, and the United states has profited from the “invest- Booth School of Business and a research associate with the fixed exchange rate systems, reduced capital controls in rich Advisers. Johnson, a former chief economist at the IMF, is co-
ments.” Those who think the return is not enough should National Bureau of Economic Research. countries, and the beginning of 20 years of regulatory easing. author, with James Kwak, of the forthcoming book 13 Bankers.
42 Finance & Development March 2010 Finance & Development March 2010 43