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The Progressive Economics Forum

Canada Breaks Rank on Banker Bonuses

Canada likes to think of itself as the country that emerged from the financial crisis squeaky clean. Too bad it is abdicating a leadership role in creating a safer financial system going forward.

The issue is bonuses paid to top executives in the financial sector. It looks like the Europeans and Americans have hammered out an agreement to put some limitations on these bonuses at the upcoming G20 meetings. In fact, all the G20 countries might sign on. Everyone, that is, except Canada.

Why the fuss about bonuses? This issue surfaced in the aftermath of the financial crisis as experts sought to understand how the financial system could go so wrong so fast. Why were so many iconic financial sector firms involved in dubious activities that culminated in such a huge mess?

One factor in the noxious brew concerns executive compensation. In economics lingo, the prevailing executive bonus system can create a perverse incentive. Financial rainmakers get large bonuses when they generate high profits. These high profits tend to go hand-in-hand with heightened risk exposure. This encourages executives to juice up their current bonuses by exposing their firms to elevated risks – risks that might go sour at some point. But the bonuses are paid soon, and the bad risks may only start exuding a foul odour later.

After all, the financial wiz kids don’t have to give back the bonuses if it turns out that they were paid on the basis of profits that later self-destruct. And many financial executives will have moved to other positions by the time the powder-keg blows, so it is somebody else’s problem to clean up the mess later.

This perverse incentive at the heart of current executive bonuses is why US Treasury Secretary Timothy Geithner has concluded that “Compensation reform is a necessary part of building a more stable system.”

But if this important aspect of financial reform is going to work, all the G20 countries must stick together. Let’s say one country ignores the G20 guidelines and lets its financial sector pay any sort of bonuses. This will create a haven for the dubious practices that goose up bonuses only to bring tears down the road. Any financial sector firm that wants to encourage its executives to engage in these sort of risky practices will locate its activity in the jurisdiction that is tolerant of short-sighted bonuses practices.

So consensus among the G20 is critical to making the new bonus limitation work. As British Treasury Minister Stephen Timms insists, “We can’t have different countries played off against each other on the question of banker’s bonuses.”

Thus far it seems that Finance Minster Flaherty may be the only G20 official to break ranks on executive bonuses – thanks in large measure to the persuasive powers of the Canadian Bankers Association who think that decisions about executive compensation should remain with banks boards of directors. According to the Globe and Mail- Flaherty will deal with the bonus issue by asking the Office of the Superintendent for Financial Institutions to take pay practices into account in its regular reviews of banks. This mild promise does nothing to conceal that our finance minster refuses to put his foot down.

If Canada fails to sign on to these proposals, it signals that Canadian financial regulators are less serious than their counterparts elsewhere in curbing the excesses produced by short-sighted bonus schemes. It would be a bitter irony if Canada compromises the reputation it earned in the last financial crisis only to put out the welcome mat for the kinds of dubious activities likely to promote another financial crisis.

Enjoy and share:

Comments

Comment from Leigh Thomson
Time: September 23, 2009, 7:37 am

“Flaherty will deal with the bonus issue by asking the Office of the Superintendent for Financial Institutions to take pay practices into account in its regular reviews of banks.”

vs.

“limitations on these bonuses”

As you and others have noted, we know that bonuses for short term profits are a problem, skewing the financial system to short term and structural roguery.
We don’t need to “review” this, as Flaherty lamely options. It’s time for some hard action.

Comment from Toby Sanger
Time: September 23, 2009, 9:31 am

Excellent piece, Ellen.

I find it really startling that this issue hasn’t been pushed by any of our opposition politicians, of whatever stripe–unless I’ve missed it.

Paul Krugman recently noted that limiting banker bonuses isn’t just good politics, but it’s good economics as well:
http://www.nytimes.com/2009/09/21/opinion/21krugman.html

And, surprisingly, in his first really significant speech after becoming governor of the Bank of Canada back in March 2008, Mark Carney stated that “misaligned incentives” were one of the three major causes of financial market turbulence. As part of this he talked about “remuneration structures of financial institutions”. He wimped out on the question of regulation of these (not surprising, given his previous, and current, employment), but at least he identified it as a major problem.
http://www.bank-banque-canada.ca/en/speeches/2008/sp08-3.html

And of course there is the further problem of tax measures and loopholes that provide an incentive for this and other forms of compensation and income that encourage speculation.

Comment from Paul Tulloch
Time: September 23, 2009, 4:57 pm

I to have wondered why this has not been mentioned in Canadian circles. I am sure the bankers are doing there best to silence such voices.

I wonder how the Canadian bankers will get through this. I know if it were me, I would be pounding my hammer as hard as I could on anybody or thing that raised the issue.

You will not see much coming from the tories on this, you can be assured of that. However, this will be an interesting case where more progressive voices external to us, force our financial system to make these reforms or suffer some kind of penalty.

I wonder, if the American financial system is as big as it is, will have enough in terms of hegemony to transform banking bonuses in Canada. It seems to be something that has got to be systemic across the board within at least regionally integrated financial systems. i.e. when the Canadian banks made there way south of the border and opened up there exposure, will this be enough for some kind of US SEC or financial regulatory commision to demand such practices for international bankers.

Hopefully it will get the external pressure, as you can be rest assured you will not get a lot internally. The cabadian bankers will be holding up their rain soaked cardboard placards of telling us how successfully the weathered the finanical storm and such measures are not needed. Who wants to bet on this, that you will see that headline in one of the major newspapers in the next couple days.

We canadians as so blessed to have such visionary and altruistic bankers, that to even think that bonus pay should be regulated will be deemed the storyline. I wonder where the liberals stand on such a policy? This could be something for the election to focus on.

banker pay and bonuses- oh what a fun campaign issue that would be! some kind of natural resonance with just about every working person in the country. sweet!

Comment from rcp
Time: September 24, 2009, 6:24 am

I guess I’m skeptical, although I agree this could be turned into a political stick to beat bankers with.

It seems clear that the UK and the US banks had a big problem with badly-designed incentive compensation (and an even bigger one with risk management in general). However, Canada has (so far) had much less of a problem.

How do the US and UK problems prove that Canadian bank compensation practices need changing? And if a change is needed, wouldn’t a simple shift to a longer-term focus arguably be sufficient?

Comment from Leigh Thomson
Time: September 24, 2009, 9:53 am

Canadian taxpayers have had to soak up toxic stupidity from Canadian bankers via the Bank of Canada. see other posts on this. Further, the purchase of US and UK banker whim chips by Canadian bankers is continuing, with no stoppage in sight under Hapless and Flahccidy.

Bankers continue to get excessive profits, compared to those who foot the bill, and as Toby and others have noted, additional loopholes and subsidies. Caps and a tie to long-term Useful function are needed, and both only a small part of regulating the entire ridiculous casino.

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