April 28, 2009 1:15:28 am
Tucked away in RBIs six-volume report on Indian banking is the observation that wondrous moderation applies to pay scales of Indias public sector bankers. The contrast is not just with Indias private sector banks the report points out that the chief of Indias largest public sector bank earns 45 times less than his private sector counterpart. The implied and more important contrast is with private banking in the West.
RBI is in excellent company on this. The link between private bankers compensation structure and the crisis in private banking is mainstream discourse in the West now. Policy wonks,politicians and the people are debating whether the way to fix the problem of bankers pay is to just let governments fix bankers pay.
This will be tough to implement. And it sits poorly with the idea of private enterprise. But those understandably angry about super-compensated bankers apparently getting away with it should have a little more faith in an institution many of them consider to be a part of the problem: the market.
If private banking changes its character,bankers pay,shall we say,will be marked to market. The real debate should not be about bankers pay. It should be about bankers work.
In a brilliant study of pay structure in US financial firms (nber.org/papers/w14644.pdf),Thomas Phillipon and Ariell Reshef demonstrate that just as in this pre-crisis banking boom,in the pre-30s boom,bankers pay rose sharply vis-à-vis that of white collar professionals in other industries. They also show that between the two booms,the pay differential smoothened out.
Now,textbook explanations say high pay has a lot to do with high-level skills. Phillipon and Reshef,however,show that the strongest explanation for high bankers pay in a boom is the boom itself. When banking is lightly regulated,bankers pay jumps. How does this sit with the undeniable fact that the boom before this crisis did see a lot of very smart people joining banking? The quants scientists and mathematicians who modelled risk for financial firms and created complex financial products are the butt of jokes now. But its silly to say they were not smart people.
Andrew Sheng,ex-chief of the Hong Kong Securities and Futures Commission,wrote a paper (An Asian View of the Global Financial Crisis) for the Caijing magazine (english.caijing.com.cn) soon after the crisis broke. It remains one of the best analyses of the crisis and it makes a very important and interesting point about the quants.
Scientists and physicists laid off by the end of the Cold War,Sheng points out,became financial engineers. Business schools,hedge funds and investment banks were full of them and their math. Nassim Nicholas Taleb makes a similar point more acerbically and with a broader intent (we are all delusional about our ability to estimate and prepare against risk,he argues) in The Black Swan. Taleb talks about East European quants with thick accents and an unvarying belief in their models.
Its the model that should be at the heart of the real debate about bankers. What was the smart work by smart people actually all about? It would not be unfair to say private banking in the West would be happy if this debate didnt take place. Theres no problem with securitisation (creation of complex financial products) this will be a happy conclusion for private banking.
But it isnt that easy. In an earlier comment in these pages (Of market and math,November 24,2008),this correspondent had pointed out that the theory behind boomtime financial engineering came up short when the conflict between risk distribution (sought to be achieved by bundling of assets) and information asymmetry (not all participants had equal idea about risks) began to bite. We had also drawn attention to the critique that the assumption behind all risk models was that returns to financial investment were normally distributed (that is,no extremes). As Sheng says,what the modellers thought would be a once-in-400-years event happened in their,and our,lifetime.
Unless these theoretical questions are resolved and the practical policies attached to them thoroughly sorted out leveraging has to be more conservative,complex financial products cannot be traded without a market clearing mechanism of the sort there is in equities trading private banking must not get back to business as usual.
This point helps us understand better at an intuitive level Philippons and Reshefs proof that it was the boom and not financial engineering skills that determined bankers pay. The quants were skilled. But their work was also fundamentally flawed.
Does Wall Street,whats left of it mid-sized Wall Street firms are coming up,recruiting aggressively,paying handsomely for staff want this fundamental flaw to be brushed aside? A case for this hypothesis,in a broader perspective,is made by Simon Johnson,ex-chief economist,IMF. His long piece in The Atlantic Monthly,provocatively titled the The Quiet Coup,argues that a financial oligarchy has more or less captured US policy and is blocking real reform. This sounds like Russia or a Latin American banana republic! And thats precisely Johnsons point.
It is possible to differ with the broad sweep of Johnsons argument and still ask whether Washingtons solution to the crisis will involve a fundamental reassessment of bankers work. And whether banks that are technically insolvent see the IMFs April 2009 edition of the Global Financial Stability Report for scary numbers on toxic assets will go through a real cleansing.
You dont have to believe in conspiracy theories to see that a return to more-or-less status quo ante would suit post-crisis Wall Street fine. Post the 30s crisis,Western private banking for decades became the plain vanilla,highly regulated type. Commentators and analysts have a favourite phrase for this type of banking,3-6-3 banking: borrow money at 3 per cent,lend at 6 per cent,be at the golf course by 3 pm,no time or inclination obviously for complex financial products.
If private banking returns to some version of 3-6-3 banking after this crisis,bankers pay will get severely moderated,as can be deduced from Philippons and Reshefs study. No deregulation-inspired banking boom,no masters of universe type salaries.
Regulated,thin profit-margin private banking has its own set of implications. For example,more than a few experts worry that such a system would dry up capital flows to emerging markets.
But that is also part of the debate about bankers work,which we should be concentrating on. We should stop bothering about bankers pay. The market will take care of that.
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