It is undoubtedly sensible that any employee's remuneration is aligned to the longer-term interests of the business that employs him or her. Therefore, it goes without saying that remuneration policies that encourage excessive risk taking should be avoided. It is also likely that from time to time, companies, themselves, will get it wrong - that they will institute remuneration regimes that, with the benefit of hindsight, turn out to be inappropriate. But it is wrong to believe that the financial crisis was brought about by a relatively small number of people who, again with the benefit of hindsight, were paid bonuses that were excessive, on the basis of remuneration regimes that seemed to encourage undue risk taking.
The real problem is that the authorities (and we can include in this generic term an unholy alliance of finance ministries, central banks and regulators) fostered an environment prior to the crisis that encouraged the whole financial system to under-price risk. At the core of this was the decision by the Federal Reserve in the US and the Bank of England in the UK (following the inflation remit set by the Treasury) to set interest rates that were too low for the economic circumstances of the time, for a prolonged period. Crucially, they did this in order to encourage borrowing - that, after all, is how interest rates influence activity. And, by definition, the lower interest rates are set, the more risky will be the lending. Had interest rates been higher, banks would have assessed the risk of lending, and the subsequent securitisations, in a different light. So the process that encouraged risk to be misidentified started with the authorities, and we should look through the smokescreen that they are trying to put up, and identify the true problems of poor policy decisions and poor supervision.
Ironically, if the authorities are now to get involved in pay and bonuses, in a way that might be seen in a command economy, they will be in danger of creating an even greater disconnect between remuneration and business performance. In this context, we have to beware the law of unintended consequences. For instance, the action taken to restrict bonus payments has already put huge upwards pressure on basic salaries, raising the cost bases of many financial companies. Inevitably, this reduces the flexibility of costs to different financial circumstances.
Richard Jeffrey is Chief Investment Officer of Cazenove Capital.
