Friday, February 20, 2009

Bankers and risk and compensation

Jamie Whyte looks at government plans to change banking compensation. I think that he has it right here:

The financial crisis was caused not by bankers’ incentive plans but by a systematic failure to price risk correctly. Without accurately priced risk, there is no way of giving bankers the right incentives, however long the period over which their performance is measured. And with accurately priced risk, there is no incentive problem to be solved.

As he says, a lot of the incentives are already fairly long-term; the problem appears to have been in the price of risk. The huge flow of liquidity into US and UK financial systems seems to have distorted all pricing and affected risk assessment. The bonus payments were there a long time before the risk premia started to collapse. There may have been a monemtum in the bonus payments and the risk-taking, but this does not seem to be the fundamental problems to me.

For another look at banking compensation see The Epicurean Dealmaker for an overview of the development of bonus culture or Chris Dillow.

The fact that excess leverage and risk-taking came across the system suggests that this was not the major feature. The relatiionship between risk-taking in the US and UK and the bonus culture seems to be confounded by the fact that the inflow of liquidity to these major financial centres meant that they were sure to suffer the most when the tide went out again.
Let's get control over the amount of money in the financial system as a whole rather than start a witch-hunt.

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