Institutional shareholders must accept a major share of the blame for bankers' excessive compensation, and at some point will have to up their game if they do not want to lose ever more influence on their businesses to politicians.

Nothing in the debate about the causes and consequences of the financial market crisis that started in 2007 creates so much passion as the question of compensation in the banking industry.

Some commentators think that excessive pay was a main contributing factor in the demise of a number of major financial institutions.

The failure of these institutions also seriously harmed other banks, and above all the citizens in many countries, where governments were left with no other choice but to spend a large part of their tax revenues on rescuing the banking system.

Excessive remuneration

But banking pay was already the subject of much critical comment before the beginning of the crisis. For example, former Morgan Stanley banker Frank Partnoy said in the Financial Times in 2005 that "no other industry serves employees better, at the expense of shareholders".

Can we now say, with the benefit of hindsight, that excessive remuneration of professionals in the banking and securities industry was a major contributing factor in the credit crunch?

Banks, and even whole banking systems, have always been prone to experiencing problems – as the Scandinavian crisis of the early 1990s demonstrates. This is why the sector has always been the object of close regulatory supervision. But excessive compensation of bankers could hardly have been a major contributing factor in these previous crises, as banking pay at that time had not yet reached such elevated levels compared with other industries.

A simple explanation for the scale and the impact of the recent credit crunch is the tremendous expansion in the volume of financial transactions during the past 30 years. For example, the total equity capital of Goldman Sachs at the end of the 1970s had not even surpassed $100million. Not only were the individual profit shares of the partners on average less than $1m then, but the volume of business was such that a bond position of $5m in a corporate bond was still a serious worry for the risk managers at the time.

Barking up the wrong tree

Trying to stabilise the banking system by controlling the compensation of banking professionals means that regulators, academics and commentators are barking up the wrong tree. High compensation is a consequence of the enormous growth in financial transactions.

In addition, as in the field of sport, the ‘star system’ contributes to pay escalation as all institutions are trying to hire the ‘best’, and it is unlikely that this will change in a service industry where individual performance contributes so much to success or failure.

The main test for the success of any reform of the banking system would have to be the prevention of any need for taxpayers to rescue banks in the future. By that standard, the plethora of new laws and regulations that has been implemented or proposed until now falls far short. Will changes to the level and system of remuneration of financial service professionals contribute to creating at least a more stable banking system?

Pay reforms will certainly make banks more bureaucratic and risk averse. If that also makes them more stable, the reforms may well qualify as a success in the eyes of some.

But specific reforms, such as paying a higher proportion of compensation in the form of shares or holding back bonus payments for a number of years, will at best offer a marginal benefit. Employees of Lehman Brothers and Bear Stearns, for example, had been paid in shares and options for years and still their banks went under. And it is doubtful whether absolute pay limits or moral suasion will be much more effective.

Wider discussion

A much better way to look at compensation in banking would be to see it as a part of the wider discussion about executive pay in general, and top-executive pay in particular. Related to that is the explosion of pay in the field of money management, especially in private equity and hedge funds, where pay for some ‘stars’ reaches hundreds of millions, if not billions.

Banks compete for the same pool of talent as money management, and pay in those sectors will continue to exert a strong – and growing – pull in the direction of higher salaries. As long as the rise in the pay of professionals in those sectors is left unchecked, there is little hope of bringing pay in the more traditional areas of the banking and securities industry under control.

Sharing the blame

Institutional shareholders have to accept a major share of the blame for excessive compensation and at some point will have to up their game if they do not want to lose ever more influence on their business to politicians.

The largest 30 fund management institutions often control about 50% of the shares in major listed corporations and should be difficult to ignore if they oppose remuneration schemes. It is time for them to rise to their responsibilities and make a meaningful contribution to the debates about how to reform the banking system and executive compensation in general. As many of these firms are in turn part-owned by banks, and their management and employees are beneficiaries of pay escalation, it remains to be seen whether or not they can jump over their own shadows.

Heinz Geyer is managing director and co-founder of specialist financial services recruitment consultant Temple Associates, and a former capital markets banker with Goldman Sachs, Smith Barney and Bank Austria.

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