Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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.

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