Ask Why, Not How
A New Year, as the old joke has it, is a fresh start for old habits. This is certainly true of the securities industry, where January marks the start of the most important event in the calendar: the annual bonus round. It takes place this year in an atmosphere of unprecedented public and political hostility toward the bankers, investment bankers and mutual, hedge and private equity fund managers that populate the industry. Even the G20 has not considered castigating the pay of bankers beneath the consideration of the leaders of the world. In the United States, only a year has elapsed since President Obama promised a tax on bankers to "recover every single dime the American people are owed." By then, the Federal Reserve had already published incentive compensation guidance for the largest banks. Dodd-Frank requires all financial institutions with more than $1 billion in assets to disclose their incentive-based compensation structures to the regulators. European Union (EU) rules now oblige senior bankers to defer two-thirds of their annual bonuses for 3-5 years, and take half of them in stock rather than cash. EU Internal Markets Commissioner Michel Barnier has made little secret of his hostility to the remuneration practices of the industry. He has told banks they need to "change radically their practices and the mentality that have led in many cases to excessive risk-taking and contributed to the financial crisis." In the United Kingdom, the Financial Services Authority (FSA) has published a Fed-style Remuneration Code for the biggest banks, which is more prescriptive even than its American counterpart. Last year, the outgoing British government imposed a windfall tax of 50% on all bonuses above 25,000. This was straightforward politics of the most disreputable kind, in which a government imposed a differential rate of taxation on a particular social group because a political party facing electoral defeat needed a scapegoat. If an ounce of honor remained in British public life, this decision would be reversed. Instead, the incoming government has chosen to retain the tax this year.In Europe, steps are now being taken to extend the politics of expropriation to the hedge fund industry. In July this year, the European Parliament and Council of Ministers agreed to extend the detailed prescription of remunerationincluding bonus restrictions under the Capital Requirements Directive (CRD) from investment banks to fund managers. Member-states are expected to implement by January 2011 a measure calling for hedge fund managers to cap bonuses, defer 40% or even 60% of performance payments for 3-5 years, open them to recovery by investors if performance is particularly poor, and ensure the money is available to third parties if the firm gets into difficulties. Bank-style linkages of this kind between the remuneration of fund managers and longerterm measurements of investment performance have also found their way into drafts of the notorious Alternative Investment Fund Managers Directive (AIFMD) and the new version of the Undertaking for Collective Investment in Transferable Securities (UCITS) directive that governs mutual fund managers in Europe. It is obvious that these developments owe everything to that unreasoning distaste of Continental European politicians for hedge fund managers that spawned the AIFMD in the first place, since even the de Larosiere report absolved hedge funds of playing any part in the financial crisis of 2007-08. Certainly it is hard to see how the failure of even the largest and most outrageously leveraged hedge fund could pose a systemic risk, especially in the light of what is now known about LTCM. Even if an overheated European jack-in-office decided that hedge funds did pose a systemic risk, he or she would be better advised to manage the risk through the investment banks that finance them. The FSA may be embarrassed by the European maneuvers, but it has no choice but to comply. It has published a consultation paper on the necessary changes to its own remuneration code. The recommendations include paying half of bonuses in stock and deferring for 3 years the payment of 60% of any bonus over 500,000.What is most depressing about this sequence of events is not the want of moral or political courage on the part of the FSA. It is the intensely political nature of the argument for taking measures of this kind at all. It holds that banks drive a cycle of boom and bust that lays waste to the "real" economy while bankers enrich themselves, only to insist on being rescued by direct infusions of public money capital and aggressive loosening of monetary policy when threatened with failure themselves. That it is a politically convenient narrative for governments that lost control of public expenditure and monetary conditions is obvious. But it is not obvious that political expedience should become the principal justification for policies that hold that all will be well if bankers and hedge fund managers are made to wait 3 years for two-thirds of their annual bonus. If preposterousness were the only fault in this train of thought, it would be harmless enough. But it has real consequences, and not just for hedge fund managers and investment bankers working in the EU. It has freed politicians, regulators and central bankers of the need to consider a far more interesting and important question: Why is personal remuneration in financial markets so high? Paul Woolley, the former fund manager now behind the Centre for the Study of Capital Market Dysfunctionality at the London School of Economics, has calculated that in 2007 the banking industry accounted for 40% of corporate profits in the United States and the United Kingdom, even after the investment banks had paid salaries and bonuses to employees equivalent to 60% of net revenues. The bonus numbers at the peak of the credit boom were staggeringly large. It is estimated that in 2007, Wall Street firms paid out bonuses worth an estimated $33.2 billion. Their equivalents in the City of London were paid 10.2 billion that year.There are many reasons why investment bankers, hedge fund managers and private equity fund managers are able to pay themselves this much. They include asymmetry of information (sellers knowing more than buyers) and opacity of profit margins (ditto). In the securities industry, the sheer scale of the numbers, the complexity of financial instruments and vehicles, their often lengthy terms and the lack of disclosureor, indeed, the equally obfuscating excess of disclosure means opportunities to exploit the ignorance of clients are legion. If you want to make money, work with money, as Bernie Cornfeld is supposed to have said. The means of exploitation include collateralized debt obligations and credit default swaps, but they do not need to be complicated. Invisible will do as well as arcane. The principal source of revenue at any bank is net interest margin, or the difference between the price the bank borrows and the price it lends. Even minor variations in this spread have large effects on revenue and profits. Likewise, fund managers enjoy access to money on terms that are better than free. They typically charge 2% for managing it, irrespective of performance. They might lose half the money entrusted to them, or even all of it, and investors are still not entitled to ask for their money back.But customers of the banking and asset management industries suffer from more than their own ignorance. They are also foiled by the principal-agent problem. This bedevils all forms of enterprise in which the managers of capital are not the same as the owners of capital, but investment bankers have exploited this space to an unusual degree. They are pioneering a new form of capitalism in which the bulk of the profits accrue not to those who furnish the capital (the shareholders) but to those who use it (themselves). Only professional sport can compare with it. Of course, both sports stars and investment bankers would argue that capital and ownership are reunited in their own talent. That is certainly why investment bankers, like professional footballers, are rightly described as mercenaries. A successful investment banker is no more embarrassed to change employer for more money than a professional footballer is to change clubs for the same reason. This is not solely because they expect large rewards, and defect when they are refused, though they do. It is because those rewards depend in large part upon selling and reselling who and what they know. Indeed, few successful investment bankers are interested in becoming the CEO, for that would mean climbing the hierarchy, and losing contact with the clients or the markets that is the true source of their rewards. But it does leave the owners of investment banks with an exquisite dilemma. Without talented people, the firm is worthless. With talented people, the firm is also worthless. The industry used to resolve this dilemma through the partnership structure. Since it was the capital of the partners that was at risk, the partners were entitled to consume all of the profits. As it happens, partnership also discouraged excessive risk-taking, and for exactly the same reason. Any regulator who refuses to believe this should ask the clients of Brown Brothers Harriman.None will, of course, just as no regulator is interested in seriously exploring the variant of the principal-agent problem at work in the fund management industry. Yet it demonstrably exists. Investors entrust their capital to fund managers, who are of course tempted to exploit it for their own benefit. This is why performance fees were introduced: To bring the interests of investors and fund managers back into alignment. The classic hedge fund, for example, collects a 2% management fee plus 20% of any return above a given hurdle (see "The red herring of 2+20," page 58, in this issue). It is commonplace for hedge apologists to argue that, as one put it recently, when hedge fund managers are making out like bandits, their investors are making out like mobsters. But performance fee structures do not always work as intended. For a start, they mean that fund managers are not rewarded for staying out of markets, even if they believe that to be the best investment decision. They must always be in the markets, chasing "performance." In fact, adopting a contrarian strategy that results in short-term losses, even if it leads to long-term gains, is the fastest way to lose a fund management contract. In other words, far from rewarding fund managers for investment skill, performance- based fee structures incentivize fund managers to inflate asset price bubbles. There is plenty of academic as well as anecdotal evidence to support the idea that the success of most fund management strategies ultimately depends not on the talent or skill of the fund manager in picking stocks or allocating assets but on luck or judgment in the timing of entries and exits to and from speculative bubbles. There is even some evidence that mutual fund managers (whose incentives are longer term) play an important role in correcting speculative bubbles fueled by hedge fund managers (whose incentives are shorter term). A recent study of securities lending also found that mutual fund managers took less risk and enjoyed more stable returns than institutional investors, for much the same reasons. It is findings of this sort that encourage regulators to believe that altering the mix of incentives faced by financial intermediaries can play its part, alongside higher capital and liquidity ratios, in reducing the amplitude of the credit cycle. By this means, they implicitly endorse the view that the excessive rewards accruing to individuals working in financial markets owe little or nothing to merit or skill, and everything to the point in the credit cycle where the dice were rolled. Which makes it doubly puzzling why they do not go on to ask why the credit cycle exists. Perhaps it is because the answer is too painful to admit. After all, the authorities themselves are the ultimate guarantors of a system of finance whose design permits the manufacture of excess quantities of credit. That money-from nothing machine is what creates both the means and the opportunities for investment bankers and fund managers to engage in arbitrage transactions of the kind that saw John Paulson make $15 billion in a single year by betting against the sub-prime bubble. True alpha is visible only in the longest run, just as it can only be earned in the longest run. Credit adds nothing to it, but it has a unique ability in the short term to transfer wealth on the grandest scale from people who made bad investment decisions to those who made good ones. At the point in the cycle where nobody is prepared to transact business with anybody any more, and the essentially fraudulent nature of the entire system of credit is exposed, it is the taxpayer who finds himself on the wrong side of the trade. In the sense that it was taxpayers who funded the rescue of the financial system, it is not hyperbolic to say that ultimately it entailed a transfer of wealth from taxpayers to fund managers and investment bankers who happened to make the right calls. Their counterparties were merely the intermediaries. This systema system in which financial institutions are too big to failis normally described as one fraught with moral hazard. It would be more accurate to call it one characterized by moral bankruptcy. In a financial system underwritten by the taxpayer as lender of last resort, it is not just bankers who know the government will rescue them if a bank fails. Shareholders know it too, and so do creditors. They all know that if they ride the credit cycle successfully, and time their entrances and their exits luckily or well, staff and shareholders prosper. If they go badly, taxpayers pick up the tab. Not even the regulators have that much interest in monitoring the risks properly, since bank failures tend invariably to enlarge their powers and budgets. So instead of attempting to identify which banks are too big to failDodd-Frank is aimed at complex bank holding companies with $50 billion or more of consolidated assetsand to surround them with regulations designed to prevent them assuming systemically threatening risks, politicians would be better advised to examine why the banking industry is so short of competition. Gigantism in banking is not a measure of systemic risk or, as some seem to think, a cure for it. It is a symptom of the lack of competition. A 2009 study estimated that monopoly rents accounted for 30-50% of the income differential between people working in financial services and people working in other industries. These are much easier to earn when a bank is too big to fail. Governments serious about reducing remuneration in financial markets would be looking not to identify the banks that are too big to fail and surround them with regulations. It would be looking to increase competition, not reduce it by imposing heavier capital requirements and liquidity ratios and pay controls on the existing institutions. A banking industry that consisted of a larger number of systemically unimportant institutions competing vigorously for loans and deposits would not only be less risky. It would be less remunerative for the people working in it. But that option is not on offer. Instead, regulators will tinker with bonuses in both London and New York. This will have minimal impact on risk-taking. It may even exacerbate the problem by driving individuals to take larger risks for potentially greater rewards, or by encouraging them to move to jurisdictions or into investment vehicles immune to regulatory interference. Already, the Volcker Rule is spawning a new generation of hedge fund managers as proprietary trading desks are reinvented as hedge funds resourced and financed by the investment banks. The investment banks have long used in-house hedge funds to retain people. Even their prime brokerage departments servicing third-party clients can be best understood as a means of outsourcing the risk-taking function. Prime brokerage is a business in which the investment bank supplies the hedge fund managers with everything they needresearch, execution, technology, capital introductions, financing and stock borrowingto take investment and trading risks. It is not clear if increasing the size of the hedge fund industry was one of the aims of the re-regulation of the investment banking industry. It could even be argued that annual bonuses, far from increasing the appetite for risk, actually discourage it. The hedge fund managers that ended this year invested somewhere between 20% and 40% in cash, for example, were not just "locking in the returns" but protecting their own 2010 performance-related payments. The same phenomenon is observable on the trading floor of any investment bank as the bonus season nears. More paradoxically still, this hoarding of profit at the year-end is not correctly understood as personal greed. Traders are not the desiccated calculating machines of anti-banker propaganda, but in this sense endearingly human: They feel a sense of ownership in the profits they have made. Like the rest of us, speculators attach a higher value to what they have than what they might have, and wish to protect it from the risk of loss. They would be better traders if they were able to detach themselves more, not less. And politicians would make better statesmen if they were prepared to think instead of emote. There is a long history of government attempts to control private sector pay directly, which proves it has perverse and unintended consequences of this kind. The income policies of the 1970s were a farcical attempt to rescue economic policy from its own contradictions. Just as Keynesian reflationism injected steadily higher rates of wage and price inflation into the economy, so fractional reserve banking injects steadily higher doses of asset price inflation into the financial system. Trying to control directly the salary and bonuses of people working in the financial services industry is the 21st Century equivalent of incomes policy: a decision to treat the symptoms rather than the disease itself. The disease is the fractional reserve banking that lies at the heart of the boom and- bust economies of the developed world. It is the credit cycle that enables investment bankers and hedge fund managers to reward themselves lavishly on annual accounting measures of performance that owe more to the position and velocity of the credit cycle than trading or investment skill. For regulators to believe that the solution to this problem is to reserve the right to retrieve shortterm profits when they turn out to be long-term losses is not merely to set themselves a difficult technical problem. It is to refuse to confront the issue at all. The disease that is devouring our commercial civilization is so far from being taken seriously that even the milder variants of narrow- or limited purpose banking are almost universally derided as not merely improbable, but fantastical. Instead, discussion is limited to the naive instrumentalismof which direct control of remuneration is a typepreferred by the sure-and-steady men and women who regulate markets, run central banks and govern our affairs. Yet by insisting that banks increase their capital, even they are implicitly conceding that it is the ability of a fractional reserve banking system to build a pyramid of credit on a pinprick of equity that is the fons et origo of all of our problems. Instead of seeking to control the pay of investment bankers and hedge fund managers directly, regulators would be better advised to investigate the nexus of interests and rewards within our corrupt political systems in Brussels, London and Washington that makes meaningful reform of the banking system unthinkable.