Bonded Bankers

CAMBRIDGE – Since the global financial crisis, regulators have worked hard to make the world’s big banks safer. The fundamental problem is well known: major banks have significant incentives to take on excessive risk. If their risky bets pay off, their stockholders benefit considerably, as do the banks’ CEOs and senior managers, who are heavily compensated in bank stock. If they do not pay off and the bank fails, the government will probably pick up the tab.

This confluence of economic incentives to take on risk makes bank managers poor guardians of financial safety. They surely do not want their bank to fail; but, if the potential upside is large enough, it is a risk they may find worth taking.

Several solutions to this problem have been proposed, and some – such as increased capital requirements and restrictions on risky investments – are headed toward implementation. More recently, two other important solutions have emerged.

Under the first, more developed proposal, banks would undertake large obligations via long-term bonds, which would be paid only if their operations are sound. In effect, the long-term bondholders would guarantee the rest of a bank’s debts, including the riskiest ones. If the bank faltered, the guaranteeing bondholders would stabilize the most troubled elements of the firm. The bondholders – not the bank’s core operations – would take the hit.

Proponents hope that this would soften the systemic cost of bank failure. They also hope that the guarantees would motivate the bondholders to monitor banks’ activities and pressure bank managers to limit their risky operations.

The second solution that is gaining ground is to revise bankers’ compensation. Senior bank managers would be paid not in cash or equity, but in the bank’s long-term bonds, thereby giving them a larger financial stake in the bank’s long-term stability, instead of its long-term stock price. If the bank failed, it would be unable to repay the bonds, and the managers owning bonds would be that much poorer.

Bank regulators in the US and elsewhere are now seriously considering such changes, but they have yet to determine how comprehensive the compensation makeover should be. In general, though, a substantial share of senior bankers’ pay would be deferred for several years. If the bank did not survive that long, the managers would lose that money.

This could be achieved by unfunded pension obligations, which do not require that banks set aside the money in advance. Banks overseen by managers who had larger unfunded pensions weathered the financial crisis better than their counterparts, presumably because they had a stronger incentive to keep them safe.

A more aggressive approach would compensate bankers with the same bonds that guarantee their institutions’ short-term, volatile, and risky debts. As a result, bank managers would have a personal financial stake in ensuring that the risky obligations do not blow up, as they did during the 2007-2008 financial crisis. If the obligations deteriorated and the bank failed, the managers would be left unpaid. Because the obligations would be guaranteeing the rest of the bank’s operations, the managers would, it is hoped, be especially vigilant in ensuring that basic operations were safe.

By tying senior managers’ pay to the bank’s stability, the financial sector, advocates argue, would be forced to police itself. This incentive-based regulation could bolster economic stability more effectively than expecting regulators to keep pace with banks’ risky activities.

The proposal is not perfect – not least because bank managers’ compensation would still be tied to profits. If a banker is told that he or she will be compensated entirely in bonds this year, with the bank’s annual profits determining the number of bonds to be received, the banker would obviously want to boost this year’s profits – even if it required taking bigger risks.

After the banker receives his or her first bond payment, the incentives become more complex. The banker wants last year’s bonds to be paid (creating an incentive to safeguard stability) but wants a high payment this year (creating an incentive to maximize profit, which usually entails risk-taking).

Moreover, bankers could find ways to sell the long-term bonds. While regulators can require that the bonds remain unpaid by the bank, and even that bankers prove that they have not sold them, senior bankers are adept at finding loopholes. They could, for example, retain ownership of the bonds, but sell off their economic interest. Bank executives who hold large numbers of these bonds would have an incentive to lobby to dilute the bonds’ guarantee. If the bank’s financial condition deteriorated, their bond holdings might motivate them to conceal that and hope for a turnaround before their bonds were wiped out.

All of this highlights the imperative that regulators develop a shrewd and comprehensive strategy for supervising such a compensation system. Otherwise, it would lose its effectiveness. Compensating bankers with bonds helps to promote safety, but it does not let the regulators off the hook.

Despite these challenges, a new, bond-based compensation strategy could enhance bank stability considerably. Though there is no silver bullet for bank regulation, implementing such a system with care and vigilance would be an important step in the right direction.