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The EU Wants Bankers To Get A Nice Interest Rate On Their Deferred Pay

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In the war against bankers’ pay the EU has a secret weapon:

Banks should pay bonuses in debt, which would be wiped out if a bank failed, an EU banking report will suggest as Europe attempts to step up the fight against bankers’ pay.

I’ve been sort of fond of this for a while. It’s a way for bankers to eat their own cooking: if you’re a banker, what you produce, more or less, is debt, so you might as well stand behind the basic soundness of that debt by owning lots of it. You can fine-tune this theory - for instance, Credit Suisse circa 2008 produced asset-backed securities, and Credit Suisse circa 2011 produced derivatives-counterparty credit risk, so that’s what its bankers got - but the basics are sound. In particular, if you are a banker, one thing that you don’t produce - that is sort of an unwanted byproduct of your operations, imposed by regulators but not particularly liked by you - is equity, so getting paid in equity is a little perverse.1

There’s a little theoretical tension here, though, which is that there’s also good reason to think that bankers should be the lowest on the totem pole in terms of getting their money back if they blow up their banks. You could just about imagine a bank capitalized with 10% equity, 10% banker-pay junior debt, and 80% senior debt, say, failing and recovering 85 cents on the dollar. So the real debt gets paid off 100%, but where does the 5 cents go? Classically the “debt” that the bankers get is senior to the “equity” that public shareholders get, but it seems a bit rough to pay the nasty bankers before you pay the widow-and-orphan shareholders.

It sort of sounds like the Liikanen report addresses this through the simple medium of saying that the bankers’ debt “would be wiped out if the bank failed”; I suppose in the 85%-recovery case that means the 5 cents would go to shareholders, or maybe to the bailout fund.2 That way you get all the benefits of paying bankers in debt - viz., disincentivizing risk-taking - with none of the perceived costs - viz., giving them seniority to the shareholders whose money they are gambling with.

Another way of putting that, though, is that the bankers get all the costs of getting paid in debt - viz., no upside - with none of the benefits - viz., seniority. That’s bad! For them. If you imagine that bankers demand a pay package with a value of $X, then you can pay them $X in cash or $X worth of stock (at market prices) or $X face amount of debt (at market interest rates). But if you pay them in super-duper-subordinated debt, and if they can still demand $X worth of value, then that means you need to pay them, like, $1.25X of face value. Or $X of face value at 10% interest. Or whatever.3 The point is, if you don’t fail, more cash is going out the door to your employees. As the FT puts it about RBS and Lloyds versions of this plan:

For many staff, however, the arrangement proved popular, because while bank share prices were falling and no dividends were being paid, they received bonds whose par value was guaranteed, paying generous coupons.

Of course you could quite sensibly argue that bankers can’t actually demand $X, that circumstances have changed, that the incidence of pay regulation will fall on them rather than on shareholders. Maybe! But, y’know, in the “fight against bankers’ pay” there are two sides, and the side that actually sets the pay has some weapons of its own. Paying bankers in bail-in debt is a pretty sensible first cut at optimizing their pay, but it’s also quite possibly a good excuse for increasing it.

Call for bank bonuses to be paid in debt [FT]
Banks Still in Negative Vega Zone [Falkenblog]

1. BUT. Eric Falkenstein has a fascinating pair of posts up arguing that bank equity is not a vanilla call option but rather a down-and-out knock-out call option, meaning that it’s got negative vega around the knockout. (Which is in theory the strike, though you could imagine it being higher or lower.) The intuition is that payment in equity, or payment that looks like equity (which continued-employment-plus-bonuses always will), actually makes bankers risk-loving in good times but risk-averse when they’re close to default - and that things are close enough to default now that bankers are suboptimally risk-averse. How much you believe this depends on things like your time horizon for the option and your growth rate for the forward (which I’m not so sure is the risk-free rate).

If you buy it, though, arguably payment in equity looks even worse, in that it’s procyclical: when times are good, bankers have incentives to pile on risk and inflate bubbles; when times are bad, bankers have incentives to shut down and live on their salaries.

2. This is perhaps somewhat trivializing since the purpose of bail-in bonds is to keep the bank as a going concern, but still. Here is an IMF paper on bail-in bonds that basically has them senior to equity and junior to senior debt, which is perfectly sensible for publicly issued bonds but less clearly so (at least optically) for bonds-as-comp.

3. Numbers super-duper made up. There is some market evidence of bail-in debt but I don’t know whether that’s the right evidence; so Credit Suisse has 9 and 9.5% coco bonds with a fairly high floor price so maybe that’s comparable.