While it seems that the worst of the financial crisis of 2008 is over, most of the structural issues that lay behind it remain unresolved. This includes distortions in incentive pay due to government protection of investors from downside risk.
One of the main legacies of the traumatic events of 2008 was a stark reminder that many risky investments are not subject to normal downside market discipline -- when they fail, they receive publicly-funded bailouts. This distorts the supply price of risk capital and the behaviour of financial intermediaries and is economically inefficient. As Schumpeter noted long ago, the market economy thrives on a process of creative destruction. And this inevitably creates gainers and losers. The whole rationale for this system risks being undermined when a privileged few gain protection from the state.
It is tempting to focus exclusively on the massive bank bailouts in 2008. However, the issue is more than a "too big to fail" problem. If the objective is to protect citizens who invest in risky assets, then even small financial institutions will have their incentives affected by public guarantees. Protection of investors' downside risks using public money appears to be a ubiquitous feature of modern financial systems. So the recent bailouts are just the tip of the iceberg. Standard depositor protection in the retail banking sector is commonplace. However, the protective covenant of the state runs much deeper than this with a range of implicit or explicit guarantees on a variety of investment funds, such as private pensions or money-market funds.
All of these interventions subsidise the supply price of risk capital to the financial sector. Most private pension plans, which constitute a huge fraction of privately held assets at risk in a number of countries, are implicitly or explicitly underpinned by some form of state guarantee. The US government had little hesitation in seeking to guarantee investments in money-market funds in the heat of the crisis.
Bailouts could be motivated by a social concern for those whose investments fail (to the extent that they are not rich). The distributional goal at the heart of such policies may well make sense given that the losers are often not wealthy. For example, in the case of pensions, some kind of public guarantee is typically needed to encourage people to take on the risk of private pensions. There is nothing wrong per se with the social judgement that nobody should be left destitute in old age if they have saved for their retirement.
Other motivations include fear of repercussions on the rest of the economy (the “too big to fail” argument) through financial contagion or more perniciously, a reflection of the lobbying power of large investors and financiers. Either way, any government with access to fiscal capacity faces a credibility problem – it will find it impossible not to bail out investors, large or small. And such expectations are now firmly entrenched, at least unless or until the state of government finances is so bad as to make it impossible as they did, for example, in Iceland during the crisis, or as part of a structural reform it is able to credibly commit not to do so.
Cost of the interventions
Since the current financial crisis began in earnest, there have been a range of explicit bailouts of the financial sector with banks and insurance companies receiving public injections of capital in a number of countries including the US, UK, Ireland, and Switzerland. The potential costs of such interventions could have added up to many trillions of dollars. Thus, it is hard to quantify the impact of these many implicit guarantees. However, recent analysis suggests that the cost of bailouts in the UK is around £20 billion or around 1% of GDP while for the US the figure is around $100 billion, which is also around 1% of GDP (see for example Haldane 2010).While these figures are imprecise, it is clear that the sums involved are significant. And this is without even recognising that systems of social insurance and government transfer programmes insulate citizens from the true consequences of their risky investment decisions.
What are the consequences?
- What is the incidence (in theory) of the substantial government subsidy that accrues to the financial sector?
- What distortions do public subsidies induce in the behaviour of the financial sector?
- Should bailouts and subsidies affect our view of taxation and regulation of the financial sector?
In recent research (Besley and Ghatak 2011) we look to answer these questions. In doing so, it is important to take account of the effect of bailouts on both the structure and level of incentive pay. And distributional arguments need to be kept distinct from efficiency arguments, something that is frequently mixed up in the policy debates (see Wolf 2010 for a discussion).
Who wins and loses? The incidence question
When it comes to incidence, there are strong arguments, well-known in the public-finance literature, to expect that the fruits of government guarantees would end up in the pockets of financial-sector employees. Protection afforded by the state need not actually raise the risk-adjusted return to investing if the financial-intermediation sector is not perfectly competitive. Instead, it shows up in profits. And to the extent that either generating or sharing profit motivates bonus pay, these subsidies are shifted. Thus, something which was intended to help small vulnerable investors who might lose their shirts, ends up benefiting already privileged financial-sector workers. The subsidies may look like they are going to vulnerable investors. But that ignores the ultimate incidence question. Opening up the financial sector to greater competition may help. Otherwise, the rents will be captured by insiders.
Given that bailouts protect financial institutions from downside risk, there will be a tendency for too much risk taking and too little productive effort. As a result, bailouts potentially help the privileged, and they result in a less efficient financial sector. Knowing that investors will demand less of a risk premium, incentives for risk taking are increased while incentives for productive effort are diminished. So, in short, bailouts reduce both efficiency and equity.
Policy needs to respond on two fronts:
- Regulation of the structure of bonuses; and
- A tax on their level.
Regulation needs to tackle excess risk taking and that means addressing the possibility that there is too much focus on upside returns. It may for example, mean putting an upper limit on bonuses. Setting that limit would require regulators staying abreast of the evolving technology for risk taking. But this is no easy task. However, we continue to witness first hand in the gloomy economic news that continues to stalk Europe and North America what happens when the problem of excessive risk-taking goes unchecked.
Taxation can be used to address concerns about equity. The rise in the pay of bankers relative to others and the role of bonuses in this is well documented (see Bell and Van Reenen 2010). Yet if some of the high bonuses in the financial sector are simply the flip side of government protection for investors, it is reasonable to treat elevated levels of bonus pay differently from high pay that accrues to effort or entrepreneurship. In the end, there is an important social judgement involved. Taxation of bonus pay is a reflection of a society deciding to trade off equity against higher financial returns. That decision lies at the door of our elected representatives. But just as basic distributive justice is important, so is the resistance of the rising populist instinct that all bonus pay is bad. There is a legitimate need to create incentives in finance.
Aligning incentives to the common good
In a speech to the Trades Union Congress in 2011, the Governor of the Bank of England, Mervyn King noted that "..a market economy and its disciplines offer the best way of raising living standards. But a market economy cannot survive on incentives alone. It must align those incentives to the common good. It must command support among the vast majority who do not receive the large rewards that accrue to the successful and the lucky. And it must show a sense of fairness if its efficiency is to yield fruit."
The financial crisis of 2008 was to a significant extent the result of governments all over the world sleepwalking on these issues. The unintended consequences of potential bailouts were an important aspect of this. With government finances increasingly strained, these could even yet prove the Achilles’ heel of public finance. And it seems inconceivable that governments will any time soon cut loose the financial sector after the global crisis that followed the failure of Lehmann Brothers. So structural reform is the only option. But creating the political will to tackle the distortions in financial-sector incentive pay seems a long way off.
Bell, Brian and John Van Reenen (2010), "Bankers. Bonuses and Extreme Wage Inequality in the UK", CEP Special Report No. 21.
Besley, Timothy and Maitreesh Ghatak (2011), “Taxation and regulation of bonus pay”, CEPR Industrial Organization and Public Policy Working Paper No. 8532
Haldane, Andrew (2010), “The $100 Billion Question”, Comments at the Institute of Risk and Regulation, Hong Kong available on Bank of England web site.
Wolf, Martin (2010), “Why and how should we regulate pay in the financial sector?”, Chapter 9 in The Future of Finance: The LSE Report, LSE.