Wall Street Bonuses and Capital Requirement

Jean-Claude Trichet, head of the European Central Bank made excellent points about "excessive" bonuses but either he or the FT report muddled his punch line. Scroll down to the end for the FT report on his views.

Let me try to reword what I consider are the major issues involved in this whole Wall Street bonus controvery:

1) Bonuses to Wall Street bankers are fine. You cannot and should not penalize profit maximization.

2) "Excessive" bonuses by themselves do not fuel future bubbles. Past and present bonuses became "excessive" because the firms they work for themselves were and remain highly leveraged. Before the bubble and even now these firms are leveraged 30-40 times to their capital base. Hence, the incentive to take risks was and remains high since the returns of risk taking are extremely high.

Annual multimillion dollar bonuses became a benchmark of acceptable work performance.

In bull markets such rewards created the inevitable hubris in the minds of the bankers that they were "geniuses". Nothing could be further from the truth. In a bubble the word "risk" got less and less attention. And then of course the bubble burst taking down everyone including those "geniuses".

3) The way to curb Wall Street from aiding and abetting future bubbles is to increase capital requirements forcing them to work with a much lower leverage. And that capital requirement, like cost of living auto pilot adjustment factoring in inflation, should increase as the size of balance sheets increases.

4) With a lower leverage, the incentive to take "excessive" risk resulting in either "excessive" bonuses will be lower. At the same time the probability of Wall Street aiding and abetting the expansion of bubbles should also be lower.

Mr. Tricket did mention the necessity to increase capital requirement. However, too much of current media attention is focused on the immorality of "excessive" bonuses.

As I have often written, the "immorality" of excessive bonuses is more an issue with the slapdash, negligent way bailout money has been handed out than with the bankers themselves who operate within the legal parameters set by the bailout.

Recall back in the days of Bush Jr, the reigning ideology was to put total faith in discipline the Market supposedly would impose on all players. Alan Greenspan admitted in a famous confession that he had thought so but he was wrong to believe so.

You can't hang the Bushies now. So....go hang Team Obama first before sending God's "disciples" at Goldman et al to the guillotine.

Before writing checks to bailout Wall Street, Team Obama should have insisted on replacing all Board members who in theory should have supervised how Wall Street firms worked on behalf of their public shareholders, a duty they failed to discharge.

So, to blame the management is really missing the main points. Oh, by the way, the news today is Goldman Sachs has changed its compensation scheme whereby for 5 years senior management cannot cash in their options.

However, let unsaid clearly those senior guys and gals could borrow against those options effectively rendering the 5 years restrictions moot. Wall Street is indeed much much smarter than Washington DC and the press when it comes to financial exercises.

FT report:

Trichet warns on bankers’ bonuses
By Ralph Atkins in Frankfurt
Published: December 11 2009 15:00 | Last updated: December 11 2009 20:04
Awarding big bonuses to bankers could help sow the seeds of a future financial crisis, Jean-Claude Trichet, European Central Bank president, has warned.

Mr Trichet said financial institutions should be using higher profits to strengthen their capital bases rather than paying out “unwarranted levels of compensation or bonuses”.

A culture of excessive financial rewards for individuals encouraged “self-referential” and “self-serving” banking, Mr Trichet warned in a speech in London.

His comments amounted to the strongest criticism yet from the ECB of excessive bank remuneration .

Mr Trichet has long urged bankers to take advantage of an improvement in financial markets to increase their resilience in the face of a still-weak global economy.He warned that excessive pay could even threaten the stability of the financial system.

“I will say that the so-called bonus culture is one of the many factors that can drive the financial system in the wrong direction – away from intermediation to self-referential speculation; away from medium-term stability to short-term orientation; and away from being a service sector to being a self-serving sector.”

His comments followed the UK’s decision this week to impose a one-off supertax on bankers’ bonuses bonuses – a move quickly followed by France.

Mr Trichet reminded bankers that the ECB had provided the eurozone financial system with unlimited liquidity, “not for the banks themselves, but to enable them to finance the broader economy”. The economic slowdown and its impact on loan books, he said, had led to a “second wave” of writedowns.

Mr Trichet has hinted in recent speeches at ECB fears that the global financial system remains inherently fragile – perhaps even more so than before the recent financial market crises. oSpeaking in Cambridge on Thursday, he warned that policymakers might have reached the limit of what they could do to head off increasingly intense financial market crises.

“The instruments of counter-cyclical policy have been used so intensely – and more so from one financial cycle to the next – that authorities might have tested the extremes of their control procedures,” he said.

One particular concern of the ECB is that the actions taken by central banks and governments have encouraged bankers to believe that a worst-case scenario will always be averted.

In his London speech, Mr Trichet argued that the “systemic risks” revealed by the financial crisis highlighted the need for a new supervisory framework in Europe that also assessed general risks for financial stability as well as policing individual banks. Under EU plans nearing implementation, Mr Trichet is expected to head a new European Systemic Risk Board, which will be supported by the ECB. Three new pan-European watchdogs will also oversee the banking, insurance and securities sectors. But Mr Trichet told the European Parliament this week that he did not see the new European Union system as the “first best” solution. That probably reflected ECB concerns about the blurring of responsibilities between the EU and national institutions.

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