Obama and the ‘Fat Cat Bankers’—A Commentary by Jonathan Macey ’82
The following commentary was published in The Wall Street Journal on January 12, 2010.
Obama and the ‘Fat Cat Bankers’
By Jonathan Macey ’82
President Obama said last month on "60 Minutes" that he "did not run for office to be helping out a bunch of fat cat bankers on Wall Street." This assertion may mollify his constituents, but it is not consistent with his administration's own policies.
We are on the cusp of what is going to be the most highly visible and contentious bank bonus season in history. Bonuses are predicted to run into the billions of dollars, and many of the banks that got the most bailout money are paying the biggest bonuses. The two issues are intimately related—and as long as the administration continues down its too-big-to-fail regulatory path, Mr. Obama will stay in the business of paying huge bonuses to fat cat bankers. Here's how it works.
All of the banks in which the bonus-driven employees work have highly leveraged balance sheets. This leverage greatly magnifies bank profits in good times and causes their losses to mushroom in bad times. The public shareholders of these companies tend to be highly diversified against the risk of failure at any particular financial institution, so they have a strong personal interest in seeing the bankers who manage their leveraged investments swing for the fences.
On the other hand, these institutions are considered vital to the national interest, and therefore can't be allowed to fail because they are allegedly too big or too interconnected. So the managers of these banks are assured that the government will bail them out if they falter.
The bankers, in short, face a massive conflict. They have a great responsibility to the public which arose as soon as the politicians decided to guarantee the survival of their businesses. They also have a legal responsibility to their owner-shareholders, whose diversified investments in these highly levered companies makes them eager to take on as much risk as they possibly can.
It isn't hard to figure out how the bankers are likely to act in the face of this conflict between the government's interest in avoiding future bailouts and the shareholder's interest in the rewards associated with significant risk-taking. They will follow their paychecks.
These paychecks are highly rational from the shareholders' perspective. The basic pay structure is the same at all of these banks. The bankers make relatively modest base salaries and receive most of their compensation in the form of bonuses. The average bonuses will be around $500,000—$595,000 at Goldman Sachs, $463,000 at JP Morgan Chase—but some will make far more (as much as eight figures). These bonuses are big and they are unremittingly linked to performance. Together a mere five banks—Citigroup, Bank of America, Goldman Sachs, JP Morgan Chase and Morgan Stanley, all of which got billions of bailout dollars—have allocated about $90 billion for overall compensation, with bonuses comprising more than half.
What Mr. Obama and others apparently fail to understand is that the banks' own shareholders benefit from these huge performance bonuses. The bonuses are paid to those who make large profits for their employers—that is, they are linked to performance.
In our "heads the shareholders and bankers win, tails the U.S. taxpayers lose" world, neither the public's supplicant pleas for restraint nor the politicians' bursts of outrage is likely to change banker behavior. This is why the banks are doing so little (and most are doing nothing) to reduce the size of their bonuses. On Wall Street the din of populist outrage is drowned out almost entirely by the sonorous jingle of bonus money.
People say that shareholders have no control over executive compensation. In fact, it appears that a clear rule of thumb about executive compensation has emerged on Wall Street. When banks make profits, the managers keep 40%-50% of the take, and the rest goes to the shareholders, either by being re-invested in the company or paid as dividends.
John S. Reed, a former CEO of Citigroup, said a few days ago that the banks won't regain the public's trust until they reduce bonus payments. He contends that the bankers have learned nothing from the crisis, and that "They just don't get it. They are off in a different world."
Mr. Reed is mistaken. It is the government, not that the shareholders, that is incapable of making a win-win deal with our financial institutions. And it is the government, not the banks, that has lost the public's trust. The public has been giving the banks credible and convincing votes of confidence all year by bidding up the value of their shares. It cannot seriously be argued that investors are ignorant of bonus arrangements.
Politicians are frustrated because they are virtually powerless to stop the flow of bonus payments to bankers. Rep. Dennis Kucinich (D., Ohio) thinks that the U.S. should follow the lead of Britain, France and Germany and levy heavy taxes on bonuses. While such action might placate some people, it is the shareholders, not the banks, who will end up paying this tax. Worse, this sort of tax will not affect banker behavior, because it will not reduce (and probably will increase) the government's proclivity to bail out banks that have made bad bets.
There is only one way to resolve the bonus problem. We should continue to let shareholders pay their managers whatever and however they want. But we must get out of the business of guaranteeing against failure. The bankers and the shareholders who enjoy the rewards of risk-taking should be made to act like real capitalists: They should be required to assume the risks that go along with the banks' business activities.
Banks that are considered too big to fail should be dismantled into smaller pieces that the economy can digest. And the government should make it clear that it will allow these institutions to fail. When this happens, the shareholder-owners of these banks will pay their managers much more sensibly—and Mr. Obama will be able to wash his hands of the business of helping out the fat cat bankers on Wall Street.
Mr. Macey is a professor at Yale Law School and a member of the Hoover Institution Task Force on Property Rights.