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.