Bank of England Sharpens Its Claws

This compensation system encouraged traders to take too much risk because the likely gains were overwhelmingly bigger than the expected negative consequences.
Banker beware. Photographer: Daniel Garcia/AFP/Getty Images

There are lots of theories to explain the bubble and bust that wrecked so many people's lives over the past 10 years, but none is pithier than the common attitude of "I'll be gone, you'll be gone" among mid-level finance employees who actually make the big decisions about where to take risk. That's why the Bank of England should be applauded for its plan to "claw back" bonuses from traders who cause destructive losses up to six years after they're paid.

Before the 2007-08 crisis, traders got paid big bonuses upfront for trades that appeared profitable even though those positions eventually blew up their firms after they'd left. You could sell insurance against U.S. mortgage defaults that lasted 5 years, for example, estimate the total income the trade would generate over the 5 year time horizon, and then take your cut -- in cash -- during the next bonus season. If you moved to a different bank, a hedge fund or a different industry, you kept the profits but your former employer would still be on the hook if your trade subsequently lost money.

This compensation system encouraged traders to take too much risk because the likely gains were overwhelmingly bigger than the expected negative consequences. As former trader Chris Arnade wrote in Scientific American:

The incentives are clear. If you make a bunch of money you get personally wealthy. If you lose then you just go home and look for a new job.

Losing lots of money is hardly the career ender that outsiders imagine. If traders lose big then they will get fired, but they will now have experience. If one loses really big then one has almost a badge of honor. One could not be allowed to lose $1 billion unless one was really important.

After the crisis, banks modified this system somewhat, deferring cash bonuses and giving more of the employees company stock, both of which limit the immediate payoff for taking risk while increasing the pain an individual trader would endure if he (it's almost always a "he") ended up doing something particularly destructive. While these are steps in the right direction from the perspective of the taxpayers who ultimately stand behind the banks, and from the perspective of the shareholders who bear the brunt of the losses when things go wrong, it's unclear how much progress has been made.

Thanks to a recovering economy and the passage of time since the initial post-crisis bonus deferrals, big cash payouts are back. Average cash bonuses for workers in the securities industry were up 15 percent in 2013 compared to 2012. It was the third best year on record after 2006 and 2007, according to the Office of the State Comptroller of New York.

One wonders how many of those bonuses were paid for trades that created significant hidden risks. Banks have had years to accumulate risky positions, encouraged by the Federal Reserve and other central banks. Interest rates have risen somewhat from last year but dodgy corporate borrowers, subprime car buyers and even the beleaguered commonwealth of Puerto Rico seem capable of raising lots of money at low cost. The Mexican government has been issuing bonds in dollars and British pounds that don't mature for a full century. Things may work out smoothly as the Fed shifts from boosting the economy to holding it back, but they may not.

The Bank of England's proposed rules wouldn't kick in until 2015, which would be too late to save us from whatever shenanigans have occurred over the past few years. But they would still be a good start.

(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter at @M_C_Klein.)

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

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