Compensation practices at financial firms stand accused of being the primary cause of the recent global financial crisis. Restricting bankers’ pay is said to be the answer. But will such restrictions work?

Before instituting such invasive regulation, we should examine whether past compensation structures really were the catalysts for our recent problems. To say that they were implies three things: top bank executives were rewarded for short-term results with large amounts of up-front cash; bank executives did not hold sufficiently large amounts of stock to align their interests with those of shareholders; and executives with more short-term pay and less stock ownership should have had the greatest incentive to take bad and excessive risks, and thus should have performed worse in the crisis.

Two economists, Rudiger Fahlenbrach and Rene Stulz, tested these implications by studying the CEOs of almost 100 large financial institutions from 2006 to 2008. They started in 2006 because that seemed to be the point at which some financial firms took on the risky positions that led to the crisis.

In 2006, the CEOs took home US$3.6 million in cash compensation on average, which represented less than half the total compensation. The larger share of pay was in restricted stock and options. At the same time, they held an average of US$88 million in their firms’ equity and options. In other words, they left more than 24 times as much in their firm as they took home. So it seems unlikely that this up-front cash provided much of an incentive for the average CEO to knowingly take bad or excessive risks that would jeopardise their much larger equity stakes.

Moreover, these CEOs lost a lot in the crisis. From 2006 to 2008, the average CEO lost US$31 million in his or her holdings of a firm’s stock, dwarfing any gains from cash compensation. The CEOs lost on their options as well.

So, if pay and front-loaded incentives were not the reason that banks’ CEOs got their firms (and the world) into a mess, what was? Some economists point to highly expansionary monetary policy in the years leading up to the crisis. Others cite the so-called “capital glut” — large inflows of external financing from China and much of the developing world. Still others highlight the role that the political system played in inflating the banking sector and real estate prices, particularly the subprime sector. Ruling out compensation practices hardly leaves us at a loss for culprits.

While today’s proposed pay restrictions are unlikely to stop the next financial crisis, they are likely to damage the financial sector. To see why, it is important to understand why bankers are paid so much.

Over the last two or three decades, technological change and increased scale have led to much greater productivity and much higher incomes for those at the top of society’s income distribution. Corporate executives manage larger companies.

Investors manage much larger sums of money. Entertainers and athletes appeal to larger audiences. Lawyers oversee bigger transactions and cases. Pay for all of these groups has increased by much more than pay for the average worker.

Given this reality, the best bankers, traders, dealmakers and so on will work for companies that provide the most attractive compensation. Greater pay regulation will drive the most talented away from regulated banks and towards hedge funds, private equity funds, boutique investment banks and other unregulated investment firms.

This talent drain is likely to be exacerbated as pay regulations impose a one-size-fits-all regime. Why impose restrictions on a dealmaker who earns a large fee for arranging a merger that imposes no risk on the bank after the transaction has closed? The same is true for a trader who makes money on spreads rather than from taking on risk. These types of employees will be penalised for no good purpose under the proposed pay regimes.

Perhaps more troubling is that pay restrictions open a Pandora’s box of other restrictions. Indeed, politicians — eager to look good in the eyes of angry voters — are often more interested in setting limits to total compensation than they are in designing the optimal form of compensation.

Banks serve a special function in the economy that does warrant a special role for the government: not in setting pay, but in imposing effective capital requirements. Higher and pro-cyclical equity-capital requirements on banks, combined with a requirement to raise contingent long-term debt — debt that converts into equity in a crisis — is a better way forward.

The typical bank is capitalised with equity, long-term debt, short-term debt and deposits. Investment banks like Bear Stearns and Lehman Brothers got into trouble because they had too little equity capital — far less than 10%. Regulators might consider imposing pro-cyclical equity requirements — increasing the equity percentage in boom times in order to offset losses in the inevitable bust times. In addition, regulators should require banks to issue an additional amount of capital — say, 10% — in the form of long-term debt that is forced to convert into equity if the bank and the overall banking system get into financial difficulty.

In issuing contingent capital, banks would have to pay a higher interest rate than they would on ordinary long-term debt because debt investors will face the true cost of capital, not the government-subsidised cost. Over time, however, the interest-rate premium is likely to be small because higher capital requirements and contingent capital should significantly reduce the likelihood of ever reaching the triggers.

If such a contingent-capital structure had been in place before the crisis, troubled banks would have been recapitalised by the contingent debt holders while avoiding the complications and legal posturing inevitable in formal bankruptcy. Debt investors, not the government, would have bailed out the banks, making the financial crisis substantially smaller, if it had occurred at all. — Project Syndicate