An awful lot has been written about the link between "banker's bonuses" and the credit crunch in the past two years. In fact, I'd wager that every major newspaper, magazine, and other periodical in the Britain and America, whether finance-related or not, has had at least one article on the subject recently. The jist of these articles runs along the lines of: the financial crisis was caused, in whole or (significant) part, by bankers, from the CEO down, being incentivised by the bonus structure to run very large risks with their shareholder's capital. They did this because the ordinary bonus system is a particularly bad example of what can be called the 'trader's option'. The 'option' metaphor arises because bonus payments offer unlimited potential payoffs (dependent only on how much money you make - motivating you to take more risk) pitted against limited potential downside (if you lose enough money, you'll be fired, but will be able to keep the bonuses paid in prior years). These articles draw an explicit link between what is seen by many people as a wholly unfair and unjust system of pay with the financial crisis which has caused a global recession. This is, however, a vast oversimplification that doesn't stand up well to the facts.
Please don't misunderstand me. Firstly, it is very true that the bonus system is wrongly set up - it does offer people payoffs for taking lots of risk, especially 'blow up' risk. Secondly, that banks were assuming too much risk is indisputable, but it wasn't as a result of the bonus system. Why do I say this. Look no further than two poster children for the irresponsibility that brought about the crisis: Dick Fuld of Lehman Bros. and Jimmy Cayne of Bear Stearns.
According to Forbes, in March 2007, James B. Cayne was worth $1.3 billion. Richard S. Fuld Jr. was worth $1 billion. Of Cayne's wealth, the vast majority (about $1bn) was invested in Bear Stearns (BSC) stock, which had peaked in Jan. '07 at just over $171/share. When Cayne sold his more than 5.6 million shares in March 2008, he received just $61.3m for them - about $10.84/share (though he had sold several hundred thousand shares over the previous year). That represents a loss of about 94%, or roughly $900 million. Estimates of the amount Fuld lost vary widely, with New York Magazine reporting he owned 10 million shares when Lehman filed on 15th Sept 2008, and lost almost all the $1 billion. Other sources say he only held about 3-4m shares when LEH filed for bankruptcy, and lost about $250m. By Fuld's own estimate in his Congressional testimony, however, he took about $350m out of the firm over the 14 years he ran it. Whatever the truth, Dick Fuld certainly lost several hundred million dollars from Lehman's failure. Certainly no one can say Dick Fuld and Jimmy Cayne weren't well incentivised to do the best they could for shareholders of LEH and BSC - Cayne owned about 5% of the company and both men had most of their net worth tied up in the stock. Also, note that these are shares, not options or other derivatives. Additionally, both men knew their banks and the industry inside out, as they had both worked for their respective firms for almost 40 years (both started in 1969, as it happens). Cayne, having been Bear's President since 1985, had been appointed CEO in 1993, the same year Fuld became CEO of LEH. Well, the bonus-theorists contend, maybe others in the company were running risks the CEO's weren't aware of. Well... nice idea, but I'm afraid not. Cayne in particular was very encouraging of his firm's leading position in the mortgage-backed securities (MBS) market. He boasted of BSC's prowess in mortgage origination/securitisation at every opportunity in the 2006 annual report (I'd love to know if the 2007 AR was the same but unfortunately I don't have it). LEH bought Aurora Loan Services and BNC Mortgage to allow them easier, cheaper access to mortgages to securitise. Well, maybe the problem with bonuses was further down the pipeline - maybe it's the bankers and traders on the floor who were running obscene risks for short-term gains. Well, possibly, but I'm afraid this argument doesn't really hold water - you see, according to CNN, BSC was more than 30% owned by its employees, as was Lehman Brothers (according to the company). So both firms' 'big beasts' (who owned much of this employee shareholding due to their compensation plans) had a whole lot of incentive not to screw up, yet screw up they did, and badly. Reform the bonus system if you want (and it does need reforming), but don't pretend it had anything to do with the crisis. If it were up to me, I'd simply hold a percentage of each annual bonus in an escrow account (or shares that couldn't be sold) for 5 (or ideally 10) years, and use a 'malus' or clawback system like UBS or Goldman, whereby future losses are offset against previous bonuses. This would take the majority of the venom out of the 'trader's option'.
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