The Principles-Based Community

Okay, I’ve officially lost the narrative regarding what ‘principes-based regulation’, or Pabst Blue Ribbon for short, is even supposed to be. Arnold Kling:

My claim is that with principles-based regulation, you could be asking this question ["How were they [JP Morgan's CIO team] compensated on an annual basis? Were they paid a salary and a bonus, and was the bonus a function of the profitability of the group, or was the bonus a function of the hedging ability of the group?”] ahead of time during an onsite audit.

I suppose it’s true that with PBR, the government could ask JP Morgan this question. But! I also suppose it’s true that the government could ask JP Morgan this question without PBR. Kling is quoting someone named Andrew Lo, who says flat out: “I know that certainly the government can get that answer with a single phone call.” Does Kling think Lo is wrong, and that we need “PBR” first? Is that his point?

I really can’t envision what PBR has to do with anything here. It seems neither necessary nor sufficient.

The Volcker Rule for example makes some statements about how people are to be paid. Their pay can’t reward risk-taking, or something along those lines. That’s part of the Volcker Rule. Thus, under the Volcker Rule, presumably regulators could and will enforce the compensation part by e.g. asking banks how their employees’ pay is calculated. (Again, I totally assume they already can and do this though). Anyway, is that PBR? Not PBR? If it’s PBR then the Klings of the world should rejoice, as Congress is clearly already passing PBRs up the wazoo. If it’s not PBR, then who needs “PBR”?

The more this PBR thing is elaborated, the more of a red herring I think it is. At least, under the loving stewardship of Arnold Kling’s nascent PR campaign it appears to be quickly morphing into a catch-all for ‘reformist regulations [he] would like’.

To the issue of compensation itself, in a technical sense I’m not sure people focusing on ‘how compensation is calculated’, and wanting it not to be tied to profits, are really thinking things through (or even being consistent). Say you work for a bank. How big is your bonus? Well clearly (unless you have some kind of guarantee or multi-year locked-in bonuses?) if there’s no bonus pool, you get no bonus. How can there be a bonus pool? If the bank makes profits. Does a bank’s profits depend in a nonzero way on the profits of [insert group here]? Sure does! Money is fungible! Profits are fungible!

What this establishes is that, no matter who you are or which group you work for in a bank, your bonus depends in a nonzero way on the profits of your group. In other words, the first derivative of [your bonus] with respect to [the profits your group makes] is automatically nonzero. It might be tiny, but it’s not zero. There’s no way around this. Hence going around hand-wringing over whether this or that group is getting paid based on some formula that depends, at least in part, on their profits is wrongheaded. I’ll answer that for you right now: Of course it is.

Moreover, in other conversations anyway, that’s the way reformers say they want it. Look at the big push to pay people more in stock (or even clever structured products), and have clawbacks. What is that, I ask? If you get paid in stock, and/or your pay can be clawed back, then your pay depends on the bank’s profits. Which (again) depends in part on your group’s profits. If only because of that whole money being fungible thing. So – due in no small part to the tireless bleating of reformers – bank employees are already very long their own employer. It follows that if that employer makes big phat profits, those employees stand to gain, personally. Again this is all fully by intent and design because (before they glommed onto PBR a couple weeks ago) the well-meaning reformers of the world were all agonizing that bank employees were too short-sighted, didn’t have enough skin in the game, didn’t have the right incentives to make sure their bank didn’t blow up, and so on. Well, congratulations reformers, you’ve gotten your wish: bank employees’ personal fortunes are highly intertwined with their banks’ profitability (even more so than any regular employee is long his employer). Just like you wanted!

Except now you suddenly don’t want it.

So, to summarize: Bankers’ pay should be inextricably tied to the profitability of their bank – except, also, it shouldn’t. Do I have that right?

Two words come to mind here: PRINCIPLES. BASED.

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