Risk Management for the Real Economy

ZURICH—In another move to rein in compensation, UBS AG notified employees it will claw back part of the bonuses due to its best-paid investment bankers, according to a person familiar with the matter.

The action by Switzerland’s largest lender by assets is likely to further upset some top employees at a bank that already has faced problems retaining top talent and is now in the midst of a revamp of its investment bank. The UBS board has decided to take back 50% of share-based bonuses awarded last year to investment bankers whose bonuses exceeded two million Swiss francs.

Wall Street Journal, 9 February, 2012

A claw back of bonuses.  This totally changes the risk reward for employees.

Banker pay is shrinking.  See Forget the big bonuses; a pay squeeze is coming.  Tett puts banker pay into a very long term historical perspective.  It seems that banker pay was previously so high – and is it a coincidence that was right before the Depression.

The reason why banker pay matters so much is that finance does not follow the same economic laws of supply and demand as physical goods.  Many people talk as if they do, but there is at least one major difference that was clearly evidenced in the run up to the financial crisis.  Scarcity does not apply to financial goods.  So there is no natural limiting feedback loop.  Remember what happened with CDOs related to mortgages?  When demand went up, price didn’t.  Supply leaped instead.  Synthetic CDOs filled the need and there is an unlimited supply of synthetic financial assets.

The amount of financial goods compared to the rest of the economy is therefore totally flexible.  Think about it for a minute.  The world cannot be any more wealthy because there are more financial goods.  The sole result of the expansion of financial goods is to tilt the ownership of the wealth of the world away from the real economy and towards the banks and others in finance.

Limiting banker pay limits the incentive to inflate the financial system.  Clawbacks means that when the bankers and others in finance do manage to push those financial goods up anyway, any excess compensation that results can be recovered when the excess of financial goods reverses itself.

So both of these measures are Risk Management for the Real Economy.

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