Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Fri, 18 Jan 2008

Compensation of bankers (and their regulators)

Raghuram Rajan wrote a provocative article (“Bankers’ pay is deeply flawed,” Financial Times, January 9, 2008) arguing that “Significant portions of [bankers’] compensation should be held in escrow to be paid only long after the activities that generated that compensation occur.” Martin Wolf agreed enthusiastically with this idea and went further “Yet individual institutions cannot change their systems of remuneration on their own, without losing talented staff to the competition. So regulators may have to step in. The idea of such official intervention is horrible, but the alternative of endlessly repeated crises is even worse. ” (“Why regulators should intervene in bankers’ pay,” Financial Times, January 16, 2008).

I agree with the basic idea that incentives are critically important but would like to go down a different fork. Why not link the pay of bank supervisors to the fate of the banks that they supervisors? If 50% of the pay of those who supervised Northern Rock were in escrow in an uninsured deposit in Northern Rock itself, I suspect that the stress tests that the supervisors carried out would have been a little tougher. I recall reading that long ago when private clearing houses performed some kind of deposit insurance and lender of last resort functions, they did sometimes hire supervisors on somewhat similar terms. The advantage is that this proposal requires regulators to change only their own HR practices and not of everybody else in the world.

In a similar vein, investors could put pressure on the rating agencies to invest a large percentage of their rating fees in the securities that they rate (with the percentage being higher for high ratings). If this had been in force, I very much doubt whether there would have been so many AAA ratings in the sub prime CDO space.

Posted at 13:43 on Fri, 18 Jan 2008     View/Post Comments (0)     permanent link