The editorial page of the Wall Street Journal today joins our ever growing chorus of dissenters against the Wall Street pay theory of our financial crisis.
For months we’ve been arguing that the idea that the compensation structure on Wall Street caused the crisis is largely a delusion. In the Journal today, the editors raise a number of points we’ve made:
- Bank balance sheets were not piled high with risky assets purchased by bankers heedless of risk. The banks bought almost exclusively AAA and AA rated securities, which turned out to be far riskier than expected.
- The compensation theory doesn’t do a good job of explaining why some banks–Goldman and JP Morgan–fared better than others. The winners paid huge bonuses just like the losers.
- The primary causes of the crisis were all rooted on government: the ratings agency oligopoly, the Federal Reserve’s ultralow interest rates, and capital reserve requirements that encouraged too much securitization and penalised banks for actually holding loans.
Here’s the key passage from the Journal’s editorial:
Governments can’t get incentives right most of the time in their own policies. So the idea that regulators can better align banker incentives than a competitive marketplace fails the laugh test. What’s more, the evidence does not show that bonus incentives caused the late, unlamented credit mania. It is certainly true that bankers (like most human beings) prefer higher bonuses, and that bankers made risky bets on which they booked big fees. But the reality of this mania-turned-panic is how widespread the excesses were, across big banks and small, foreign banks and domestic. The companies that fared relatively better paid huge bonuses too, but they had better risk management controls.
Bankers who owned large equity stakes in their banks—and therefore had a strong incentive not to see them fail—also did not outperform their peers in the crisis. And as Jeff Friedman of Critical Review notes, banks on the whole bought AAA- and AA-rated securities almost exclusively for their own portfolios. Thus they sacrificed the higher yields of the lower-rated tranches for the perceived safety of a AAA seal of approval—hardly the behaviour of people seeking short-term gain, whatever the long-term consequences.
Far more important than bonuses were the incentives to issue and take on debt, especially housing-related debt, created by . . . the politicians who now want to blame banker pay. There’s the systemic risk that the Federal Reserve created with the ultralow interest rates that subsidized credit for so much of this decade; the privileged status bestowed upon the ratings agencies by the SEC and others; and regulatory capital rules that favoured securitized mortgages over the same loans when held in portfolio by the banks. True reform would grapple with these issues, rather than the calculated distraction of bank pay.
Going forward, the biggest systemic risk is the emerging reality that the politicians consider our biggest financial institutions too big to fail. This is a much greater incentive to excessive risk-taking than any bonus pool because it means the bankers get the profits while taxpayers absorb the risk of failure.