When do you earn too much? The not-so-new risk and reward rule

In principle, there should not be anything wrong with what you earn as long as your boss (remember: the shareholder, not the CEO) is fine with it. You produced it, therefore you earned it. A basic law of free markets and capitalism.

This understanding seemed to be in place in investment banking up to 2008. Until that year, the financial sector underwent an explosive growth underpinned by a boom in debt and supposedly risk diversification strategies and products. Value creation to shareholders was high, investors earned reaped huge profits. Employees shared a significant part of these returns through well above-the-median salaries and bonuses.


Everything collapsed at the end of 2008. During 2009, banks' bail-outs in the EU and the US became commonplace. The result so far is that the financial sector has gone back to normal and in some areas profits seem to have reached those of 2007. The black swan flew in, surprised everyone to panic and quickly hid again.

In the US, strict salary and bonus limitations were imposed on those banks and other companies that received public money. A payment tsar was appointed to oversee salaries in these institutions. In the UK, the government is now the main shareholder of the banking sector and laws have been enacted to reduce the attractiveness of paying bonuses.

Apparently, the crisis has demonstrated that the financial sector is too important to leave it fail, meaning that it should be treated differently to other sectors (whether we would have been better off without the vast government intervention in the financial sector is a topic that it is left out of this text).

More fundamentally, the financial crisis has severely exposed the weak link between risk and reward in the financial sector, a key principle of capitalism, free markets and just societies.

And the question of whether pay in banking is too high is fully answered by this revelation, for that few people criticize large profits when risks are high. Entrepreneurs are the main example, as most of its start-ups go bust – the fact that we only learn about those that are successful may make us mistakenly believe that most of them survive.

When pay is not linked to risks, you may not be rewarding performance and value creation to society and instead over rewarding:

a. Luck – see Taleb's analysis of traders in Fooled by Randomness;

b. Inequality in access to opportunities and its perpetuation– this is why we should support a large inheritance tax, but this will be the subject of another column;

c. Imperfect economic structures (oligopolies or monopolies) – self-sustaining structures that limit competition;

d. People with no distinctive skills – jobs that someone else can do it;

e. Sectors that lack strong monitoring and supervision mechanisms – there is still no regulation in place that gives shareholders a strong say on defining executives' pay;

f. Activities that may not be those that create more value – are we taking out the best people of activities such as engineering, politics, philosophy and education?

g. Moral hazard – large risks during booms and higher social costs during busts.

We should start thinking of new mechanisms to reward employees. Having bonus on good years and salary “penalties” on bad ones do not avert problems. Damage will be already done. Long-term performance bonuses may work but, what if the problems start on year 6 in a 5-year performance-linked bonus?

Societies, corporations and banks should aim at linking large pay to large risks. And banking, due to its intrinsic characteristics and its critical role in capitalism cannot afford large risks.

If banking is really core to capitalism and our societies, excessive risks should not be allowed. And, where there are no or limited risks, pay should be restrained. Even considering the great skills and dedication that most people in investment banking shows, pay should be lower. Risks and large earning should be left to entrepreneurs in other sectors. There will be huge opportunities for soon-to-be investment bankers in these areas.

And we should avoid comparing football players with bankers (e.g. why all this fuzz about bankers when football stars earn more?). Those are big risk-takers (how many football players earn more than €1million?) and great weekly monitoring mechanisms (traders do not work with more than their boss and the colleague next desk) and ample competition ensures that only the best survive without the safety-net of a bail-out.

The analysis of large earnings should incorporate the risks taken to obtain them. Where this does not happen, societies run the risk of rewarding the wrong people and creating the wrong incentives if profits are simply analyzed by themselves. We will be penalizing value creation and the development of better and more just societies.