In the paper, The Case for Intervening in Bankers’ Pay, forthcoming in the Journal of Finance, I model banker remuneration in the context of competition between banks, thereby allowing financial regulation to be assessed in the light of its impact on the default risk arising from remuneration. Bonuses are important to banks—more so than purely for their incentive effects. Bonuses have much better insurance properties than wages do as the remuneration payment is better connected with the realized state of investments, while wages add to banks’ fixed costs. If investment returns are poor then the required bonus remuneration payments shrink—just when the danger of a default event is present.
Competition between banks for bankers creates a negative externality which drives banks’ default risk upwards. Each bank bids up bonuses on teams of bankers who they do not ultimately hire. This pushes up remuneration costs for the bank which does hire any given team. For 1 in 10 financial institutions on the NYSE, these remuneration costs can represent over 80% of the shareholder equity. Remuneration payments of this size increase the risk of default of the institution significantly: a default event occurs even at smaller investment losses. Hence, the banks are forced to incur higher costs due to the increased chance of the costs of a default event (forced asset sales, higher costs of capital) being incurred.
Is there a case for regulating bankers’ pay? The impetus to regulate may actually, in part, come from outside the economics of banking—to raise money for the government or to make a statement as to the appropriateness of bankers’ remuneration in society. However it is preferable that such intervention should have the effect of lowering the default risk. Policies of taxation fall short on this measure. They do not lower default risk in the absence of corporate governance problems, and if such problems are present then they should be the focus of policy makers’ efforts. Forcing banks to be smaller exacerbates the risk created by remuneration as the banks are forced to dedicate an even greater proportion of their funds to competing in the labor market for bankers. Regulations which have their object or effect of forcing banks to use fixed wages rather than bonuses in individuals’ pay effectively increase fixed costs. Such regulations increase the risks banks bear as they will be compelled to offer large wages to their bankers which must be paid in bad as well as good times. However a cap at the bank level on the overall proportion of the balance sheet which can be used for bonus remuneration can lower bank default risk and raise bank value. An appropriately calibrated cap on the total bonus pool size would affect poaching banks more than employing banks and so would lower market rates of pay. It would also be easier for a regulator to implement than caps on individuals’ pay arrangements. This latter policy is one which, if applied correctly, can increase bank value, lower default risk and lower banker remuneration. The first two are economically relevant. The last one may be politically so.
The full paper is available for download here.