RISK AND REWARD / THE NEW YORK TIMES EDITORIAL ( VERY HIGHLY RECOMMENDED READING )

Editorial

September 12, 2010

Risk and Reward

Two years after Lehman Brothers collapsed under the weight of mortgage-backed bets that went horribly wrong, banks’ pay practices have improved but fall short of what is needed to discourage bankers from once again taking unjustifiable risks.

Bonuses on Wall Street rebounded sharply in 2009 and are in line for their second annual increase this year following the big decline in 2008, when bankers blew up the financial system. Bonuses at big European banks like Deutsche Bank also increased last year. Credit Suisse promised hundreds of its London bankers a big extra cash bonus this month after trimming bonuses last year to avoid a British bonus tax.

Amid all this activity, regulators risk falling behind the curve. Last year, the Financial Stability Board created by the Group of 20 leading economies agreed on new standards intended to discourage the kind of excessive risk-taking that ravaged the financial system.

But national regulators around the world are taking vastly different approaches to implementing the standards. The Federal Reserve and other banking watchdogs must remain ready to tighten the rules to stop banks from moving their most risk-hungry bankers and operations to the least-regulated locales.

Banks have made some progress in aligning their risks and rewards. A survey of top banks by the Institute of International Finance, a bank lobby group, found that guaranteed bonuses — paid regardless of bankers’ performance — accounted for only 5 percent of the bonus pool in 2009, down by half from 2008. Multiyear guarantees have almost disappeared. Moreover, almost 40 percent of bonuses last year were deferred over a number of years, up from less than 30 percent in 2008.

But this is still short of the Financial Stability Board’s call to defer 40 percent to 60 percent of bonuses for most bankers, and more than 60 percent for top executives. Moreover, many banks haven’t developed systems demanded by the new rules to align their bonuses with the risks of their operations over the long term. Almost half do not disclose to shareholders and the public the methods used to determine the bonus pool.

Not all banking regulators are pushing equally hard to ensure compliance. In July, the European Parliament passed a tough law forcing European national regulators to adopt the Financial Stability Board’s limits on cash bonuses by January — forcing banks to defer most bonuses and pay large chunks in shares. But the Federal Reserve is avoiding hard caps on cash bonuses. In May, the Fed gave big banks its evaluation of their individual pay practices and asked them to develop a plan to address weaknesses in their incentives structures. But the details of such adjustments have not been disclosed.

It is too early to know whether regulatory differences will spark a mass migration among banks to the least-regulated jurisdiction. But in Europe, bankers have warned that laxer rules might draw bank operations to the United States or jurisdictions like Hong Kong, where the financial regulator also decided to give banks leeway to determine how best to align risks and rewards.

Britain’s Financial Services Authority has implemented the European Parliament’s rule to the letter, but British executives have complained that other European countries — like Germany and France — are not being as stringent. This sort of regulatory arbitrage could defeat the purpose of the new compensation rules. We have seen the damage that risk-hungry bankers can inflict.