The real reason bankers are now paid tens of millions

PUBLISHED : Sunday, 22 April, 2012, 12:00am
UPDATED : Sunday, 22 April, 2012, 12:00am


Citigroup shareholders rejected its executive pay plan, a first among the six largest banks in the United States, amid criticism it lets chief executive Vikram Pandit collect millions of dollars in rewards too easily.

Bloomberg, SCMP, April 19

So here is the question. If Citigroup/bank/corp (or whatever it calls itself these days) had seen its stock rise on the market by 44 per cent last year, instead of falling by that much, would Mr Pandit be worth these extra millions in pay he is now to be denied?

Because if that's the way the reasoning works, if he is to be denied the money only because he would get it 'too easily' for the movement of the share price, then I just cannot see what all the fuss is about in executive pay.

If the purpose of banking is first and foremost to goose the share price and if it is indeed possible for senior executives to achieve this objective then of course you have to pay them tens of millions for the job. You get a hundred times this much back in a higher market valuation.

And if it should happen occasionally that your bank has a bad year, as does happen occasionally, then it's a risky business to cut these executives back to normal salaries. It may not be their fault that it's a bad year and if the cut makes them disgruntled and some other bank lures them away, you will have lost a valuable asset. The shareholders may not be pleased. Best continue to pay them millions unless they clearly prove themselves incompetent.

I can't see any fault with this line of reasoning for a bank that lives by the immediate level of its share price alone.

But now let's consider another sort of bank. This one also values its share price but thinks the best way of keeping the price strong is to build its business by attracting deposits.

This bank, however, operates in a banking system where there are no deposit insurance schemes, no government bailouts of commercial banks and no guarantees of any sort that the money is safe.

In order to get the deposits it wants, this bank must keep depositors happy that they will get their money back if they need it. The only way of doing this is be careful in advancing that money to others. If the depositors smell even a whiff of loan problems they may flee instantly.

This bank also knows that individual human judgment alone is never entirely up to the task of determining who is creditworthy and who is not. It therefore demands security for its loans and it relies on procedures and rules that its credit officers must follow. It values prudence above clever brains.

This bank pays its executives well but sees no reason to pay them million dollar bonuses. It treats banking as farming. It sows the deposits and reaps the harvest. The success of the harvest depends on the bounty of the earth and a straight furrow for the plough. The ploughman gets a ploughman's wage but is not paid for the bounty of the earth.

This sort of bank is rare these days. We now have governments that jump to guarantee every cent of bank deposits. As a result, depositors no longer much care where they put their deposits. Any bank will do. They are all guaranteed. Therefore pick the one that pays the highest deposit rate.

Bank executives know it and know that they can now dispense with prudence if they choose. They can take risks as great as they like with the deposits. If the risk works and generates a windfall profit they can take that windfall out in bonuses for themselves. If the risks fail the Ministry of Finance repays the depositors.

And, yes, it indeed makes a great deal of sense in this kind of banking system to pay executives top bonuses.

It is their skill in gearing up the assets, in finding new ideas in risky derivatives, that drives the profits and the share price. They are worth every cent of the windfall millions they are paid.

Nature specialises in irony, I think. Here we have governments around the world protesting at big bonuses for bankers when it is actually government policies that have turned normal executive pay into these squillion-dollar pay awards.

It's called moral hazard.

Tell me if you ever find a politician who understands what that means.