Reply #54: A Better Way to Make Bankers Pay for Crises?

[Demeter]

http://www.nakedcapitalism.com/2011/05/a-better-way-to-make-bankers-pay-for-crises.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+NakedCapitalism+%28naked+capitalism%29

...Since the crisis, there has been lots of debate on what to do about incentives in the financial services industry with little in the way of action. That’s because we maintain the fiction that major capital markets firm are private sector companies. Despite the fact that they enjoy subsidies vastly in excess of other industries, we can’t possibly treat them like the welfare queens they are and ride herd on their compensation levels. But it’s still worth pondering the issue of what ought to be done, since pretty much every investor I know expects another big crisis in two to five years. We had better get it right next time.

The germ of a very interesting idea came in a VoxEU paper last March which I had wanted to highlight and somehow let slip. One of the problems with the big end of financial services industry is that it is highly interconnected, so if one firm gets in serious trouble, it is likely to bring the whole network down. Yet because bankers have perverse incentives (annual pay cycles and business unit level pay for most producers, both of which encourage narrow views of risks), banks routinely try to shift risk onto their counterparites, which is fine in normal times, but a destructive posture when markets become risky (the blow up of AIG and the monolines is a classic example)...

........................................

Crisis contracts are designed specifically for members of the bank’s management. The nature of a crisis contract is as follows:

Definition of a crisis: A crisis occurs when the average equity capital in the banking system (relative to the assets) falls below a critical predefined threshold...When a crisis occurs, the top managers of major or highly interconnected banks contribute a portion of their earnings from the previous years to a rescue fund for the recapitalisation of the banking system.