Europe threatens bankers' bonuses

[derspiess]

One theory I have read is that the widespread use of stock options as incentives is counterproductive in this respect, as it encourages excessive short-sighted risk-taking - managers reap the benefits of risk (they exercise their options if the stock goes up) but not the downside.

Yeah, that's always annoyed me a bit.

[Valmy]

Banks exist to protect the deposits of their clients and to *conservatively* loan money. Turning a profit keeps the lights on, so it allows them to engage in their reason-for-existing. Turning a profit by refusing to protect client holdings and loaning money to exceptionally risky ventures is most certainly greed. I can't imagine you've lived through the 2000s and aren't picking that up for some reason.

Well from what I heard from bankers, people who did not do those things were left in the dust.  If other banks are getting higher returns, you better find a way to make your bank get those returns or you will lose capital to your competitors...not to mention your job.

[DGuller]

Arguably the problem is not risk per se, but rather mis-priced risk and/or highly correlated risk.

True enough.  It's not that the banks took inappropriate risks, it's that they didn't properly assess how risky some of their moves were.

True, but that's not the whole story.  Another problem is that you have initially very unlikely, but catastrophic risks with derivatives.  Hedging against them is pointless, because that's like buying insurance against a nuclear war.  Therefore all individual actors rationally discount the remote catastrophic risks in their decision-making, and by doing that increase the likelihood of such catastrophe.

[Valmy]

True, but that's not the whole story.  Another problem is that you have initially very unlikely, but catastrophic risks with derivatives.  Hedging against them is pointless, because that's like buying insurance against a nuclear war.  Therefore all individual actors rationally discount the remote catastrophic risks in their decision-making, and by doing that increase the likelihood of such catastrophe.

This is the main thing that makes finance so dangerous...it is nigh incomprehensible.

[Zanza]

The problem with Switzerland would be that it's one of the dullest and most boring places in the world to live. Maybe bankers are ok with that, though.

I guess they can always move to Luxembourg if Switzerland is too dull and boring. Oh, wait...

[fhdz]

Arguably the problem is not risk per se, but rather mis-priced risk and/or highly correlated risk.

True enough.  It's not that the banks took inappropriate risks, it's that they didn't properly assess how risky some of their moves were.

An improperly-assessed risk is an inappropriately-taken risk.

Because of the virtual impossibility of predicting black swan events, banks would have done well to stay out of derivatives altogether.

[Valmy]

The main thing I got from the Swiss is they were bonechillingly rude, never felt more unwelcome anywhere I went.  And I am a fan of France so it is not like I was expecting them to kiss my ass or anything.

But living  among all those mountains looks anything but boring, I cannot imagine not being able to entertain myself there.

[Valmy]

Because of the virtual impossibility of predicting black swan events, banks would have done well to stay out of derivatives altogether.

Well this goes back to my point.  Could a bank have done this?  Wouldn't the bank management have been fired in the ensuing stock holder revolt?

[Admiral Yi]

Because of the virtual impossibility of predicting black swan events, banks would have done well to stay out of derivatives altogether.

If (investment) banks stayed out of derivatives, there would be no derivatives.  One of their main lines of business is making markets in interest rate and currency swaps.

[fhdz]

Because of the virtual impossibility of predicting black swan events, banks would have done well to stay out of derivatives altogether.

Well this goes back to my point.  Could a bank have done this?  Wouldn't the bank management have been fired in the ensuing stock holder revolt?

The issue is that retail banking used to be firewalled from investment banking. With the repeal of Glass-Steagall, this firewall (which had been crumbling for some time) was taken all the way back down. My point is that we never should have breached the firewall.

[Admiral Yi]

The issue is that retail banking used to be firewalled from investment banking. With the repeal of Glass-Steagall, this firewall (which had been crumbling for some time) was taken all the way back down. My point is that we never should have breached the firewall.

The problem with this argument is that there is not one example of a full service bank who's retail bank arm's solvency was threatened by the activities of its investment banking arm.

[fhdz]

What about B of A/Merrill Lynch?

The too-big-to-fail banks' solvencies were never very seriously endangered, but this was because of the bailout. As I understand it, in essence the taxpayer absorbed the risks engendered by the investment arms of the banks. That's hardly an argument in favor of continued combination of investment/retail banking.

[Admiral Yi]

What about B of A/Merrill Lynch?

BoA bought Merrill after the shit hit the fan.  And since the acquisition I have never read about losses by Merrill's derivatives desk (or any other part of Merrill for that matter) imperilling BoA's solvency.

BoA's biggest ongoing headache has been the litigation over toxic assets picked up when they acquired Country Wide.

[fhdz]

Is this article's assessment (as of October 2011) of the situation incorrect? It's one of many I've seen with a similar bent.

http://seekingalpha.com/article/301260-bank-of-america-dumps-75-trillion-in-derivatives-on-u-s-taxpayers-with-federal-approval

[Sheilbh]

Well it not a question of greed, I mean they are banks their entire reason to exist is to make money, but rather the behavior they feel like they have to participate in to be competitive.

Society's greed. We wanted gluts of cheap credit, increasingly it offset stagnating wages.

I would expect more regulation like the Swiss one in the future. Europeans do not trust the free market to deliver the desired results for society at large.

Regulation's one thing. Pay is something the EU shouldn't be regulating and might not be able to under the treaties.

Never been there but it's in my top 3 places if I had to leave the US for some reason.

It's the worst place I've ever been. Expensive, priggish and joyless. Although skiing and raclette are wonderful.

The problem with Switzerland would be that it's one of the dullest and most boring places in the world to live. Maybe bankers are ok with that, though.

The Economist did a piece on bankers who fled London to Zurich after the 50p tax rate (which never actually came into effect). Apparently the overwhelming majority wanted to transfer back in under a year

The key is to align incentives to reward steady wealth- creation by banks and other corporations, and not spectacularly risky boom-or-bust endeavours. The difficulty lies in how to do that without stifling growth and innovation.

This is partly what Martin Wolf's column, an imaginary conversation between three implausibly well-informed MPs, discusses:
http://www.ft.com/cms/s/0/f1972a7a-81cb-11e2-b050-00144feabdc0.html#axzz2MiZaWSNS

"Not so fast," responds the Liberal Democrat. "We, too, support the recommendations of the Vickers Commission. But the problem of bonuses is not so easily dealt with. Banks tend to earn attractive returns almost all the time, offset by infrequent catastrophic losses. For someone earning performance-related bonuses, it pays to follow strategies like these. They then have a good chance of being rewarded for playing the odds successfully, rather than for true skill. Their upside is huge, while, if they are unlucky, they lose outstanding bonuses or maybe their jobs. Naturally, they bet the bank."

"It is the job of shareholders to stop that," responds the Tory.

"That's absurd," answers his colleague. "Shareholders don't have a clue. Also, with leverage of 30 to one, the equity needed to shield the public from the 'tail risks' is just not there. Management have the same upside-slanted returns as subordinate bonus recipients. So the public has a right to intervene. I do sympathise with the European Parliament."

And of course when banks fail the problem is huge. They either need to be bailed out, or, if not, still have a disproportionate effect on the rest of the economy by reducing credit supply etc.

The too-big-to-fail banks' solvencies were never very seriously endangered, but this was because of the bailout. As I understand it, in essence the taxpayer absorbed the risks engendered by the investment arms of the banks. That's hardly an argument in favor of continued combination of investment/retail banking.

Even without actual bailouts there's the implicit bailout - that the government would step in to save a universal bank (and they did). One of the BofE's members of the new Financial Sector regulator made a speech that discussed estimates of how big the implicit subsidy is and it's huge:
http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech615.pdf (and the same guy on whether we've solved 'too big to fail': http://www.voxeu.org/article/have-we-solved-too-big-fail )
Again Wolf had a bit on this:

"Keep this up and we will be back, instead," interjects the Labour member. "Andy Haldane, the Bank of England's executive director for financial stability, estimated the average annual subsidy for the top five UK banks at more than £50bn between 2007 and 2009 – which is roughly equal to UK banks' annual profits before the crisis. If something is subsidised, too much of it will be provided. That is fine market logic. So regulation must offset it. What is the realistic alternative?"