Systemic Risk Due to Bonus Based Trading and Compensation

February 15, 2009

Sankarshan Acharya
Pro-Prosperity.Com and Citizens for Development

February 15, 2009

To:       Honorable President Barack Obama
Cc:       Honorable Vice President Joe Biden
Honorable Speaker Nancy Pelosi
Honorable Senator Harry Reid
Honorable Senator John McCain
Honorable Senator Chris Dodd
Honorable Congressman Barney Frank

Sub:     Systemic Risk due to Bonus-Based Trading and Compensation

Dear President Obama,

Bankers have argued that they would lose their top producers to competing hedge funds and foreign firms if restrictions were imposed on executive compensation.[1] Some bankers have indicated that they would return the TARP funds to avoid restrictions on their compensations.[2]

The above reactions reveal the truth that the banks use bonus-based trading to compete with the hedge funds by heavily leveraging with taxpayer money.  The pertinent issue concerning the financial meltdown and bank bailout is, therefore, not just high compensations and perquisites.  It is the very structure of bank employee (not just executive) compensation-namely, a part of the trading gains being paid as bonus-that has bankrupted the American households, banks and governments. 

Bankers’ reactions confirm that bonus-based trading by banks imputes severe moral hazard (blackmailing) risk on taxpayers that becomes systemic:  It locks up taxpayer insured funds for heavily leveraged trading.  These funds could be alternatively deployed for job-creating business or for funding home mortgages at reduced rates of interests to sustain economic boom. Bonus-driven trading squeezes retirement savings of the productive households, which has brought the economy to a state of depression. 

Banks need trading for hedging and for matching of durations of assets and liabilities.  But banks need not and optimally should not compete with the hedge funds on bonus-driven trading by locking up enormous taxpayer-insured funds.  The permission to let banks become hedge funds, based on taxpayer-insured funds, has brought us to a spiraling financial depression.  

Senator Chris Dodd has summarized the speciousness of bonus-based incentives to bank employees very accurately: "These bonuses are meant to be performance-based, but too often Wall Street executives took too many risks and made decisions for short-term gains, rather than long-term viability."2

Without the bonus-driven trading compensation structure, bankers would have no incentive to generate fictitious gains, i.e., gains before meeting their underwritten obligations, and we would not be facing the current crisis.  This was the basis of my Safe Banking policy proposal made to the Congress in 2003.[3]  Safe Banking would have made banks responsible to not engage in bonus-driven trading with enormous moral hazard risk to taxpayers.

My February 14 memo on “Optimal Governance of Capital Markets” outlines how traders’ incentives to generate gains can cause severe financial depressions, continually.[4] This is now supported by the hard truth revealed by bankers’ reaction to the government’s restriction on the structure of compensation.

Bankers receiving taxpayer help-directly through TARP funds or indirectly via guarantees of deposit insurance and too-big-to-fail policy-should face limits on executive/employee compensation like the $500,000 per year with bonus paid in terms of deferred stock options, as the government has already promulgated.[5]  This compensation structure is necessary to extricate the economy from the rut of gloom and doom facing the vast majority of effective producers:   

·         This compensation structure is the only way to ensure that banks do not irresponsibly divert funds to leveraged trading.

 

·         It will ensure that banks lend all their available funds on fair terms to viable businesses that create and maintain jobs and to homeowners to generate confidence in the economy.

·         It will contain the rampant destructive bonus-driven trading, designed to squeeze retirement savings of the productive households, which has brought the economy to a state of depression.   

The financial institutions that do not receive taxpayer support (TARP and guarantees) should be allowed to operate without any restrictions on compensations.  All financial institutions should, however, be subjected to the optimal rules for governance of capital markets proposed in my memo dated February 14, 2009.

With profound regards,

Sankarshan Acharya


 


[1] “The soon-to-be-law prohibits paying commissions, which are the lifeblood of a salesperson’s income,” said Scott Talbott, vice president for government affairs at the Financial Services Roundtable, a Washington trade group that lobbies on behalf of banks. “Non-TARP companies, like hedge funds and foreign firms, don’t have this restriction, so it will be easier for them to hire the top producers away.” It will make TARP less attractive and therefore reduce participation by healthy institutions, which undermines the whole program,” Talbott said.  http://www.bloomberg.com/apps/news?pid=20601087&sid=aAylhwmdYuKw&refer=home

[2]“The executive who asked to remain anonymous said he fully expected the Treasury to ask his company to defer repayment, but he was no longer inclined to listen.” http://www.washingtonpost.com/wp-dyn/content/article/2009/02/14/AR2009021401830_2.html?hpid=topnews

[3] http://www.pro-prosperity.com/Global%20Economy%20Chatterbox/Warning-USCongress-In-2003-On-Home-Mortgage-Debacle.html

[4]My book, “Prosperity: Optimal Governance, Banking, Capital Markets, Global Trading and Exchange Rates,” (Citizens Publishing 2005) more vividly illustrates various trading strategies.

[5]This is consistent with my paper, “Optimal CEO Compensation in best National Interest,” available at the internet, http://www.pro-prosperity.com/Research/OptimalCEOCompensation.pdf