Banking pay just won't go away.

I had wanted to move on from the weary subject of bankers' pay as there are many other interesting things to write about, but Martin Wolf's provocative FT article needs consideration. His argument summarises thus: (a) banks are disproportionately important to economies (b) they know it, so capitalise on it - "no industry has a comparable talent for privatising gains and socialising losses", (c) as a result banking employees are conflicted with the rest of the world so (d) please regulate their pay.

You cannot fabricate demand for any product. You can market it aggressively, charge too much, fail to provide good service, but if that product is not wanted, it will not sell. This applies to mortgages and other financial products (e.g, dotcom IPOs) as much as it applies to iPods. The availability itself of esoteric mortgages to borrowers, and of exotic mortgage-backed assets to investors, was not the most significant factor in the growth of the present cancer. Nor was the apparent connivance of some of those in the distribution chain.

No, individual mortgage borrowers demanded their chance to improve their social and financial standing with scant regard for the potential consequences of their actions. MBS Investors (read hedge funds, money market funds, pensions, mutual funds as well as banks) demanded 'attractive' yields for the perceived risk, and had incentive structures and abundant liquidity available to encourage risk taking.

Mortgage borrowers and mortgage-asset investors were both long housing assets, the former with a call option on the upside, the latter by shorting puts on the downside for yield premium. Investment banks, at whose doors Mr Wolf et al are laying the blame for the outcome of this misguided speculation, just saw an opportunity to intermediate this activity and did so successfully. It was their own badly conceived warehousing of some of the assets which is causing them so much mark to market pain at present, but that is not the issue.

Are we supposed to blame the bankers for being oil in the cogs in the capitalist engine? Are we suggesting that banks should have desisted as they knew a bubble was developing? Why are we ready to pronounce them the bad-guys again? Purely since their pay is the most public and the most despised by outsiders. So let's regulate it. Claw it back. Withhold it for 10 years.

Never mind that politicians and central bankers set the tone for investors (loosely, the American dream). They don't get paid much, so let's not blame them. Let's also not claw back their salaries or appropriate large fractions of their fees from lucrative speaking tours or book sales following their exit from public duty.

Never mind that the majority of ordinary people are illogically risk seeking in housing markets, or dot com shares. Ordinary people don't get paid like bankers, so let's not blame them. Let's not try to educate ourselves properly about finance before we wreak such destruction.

Never mind all that. Blame the intermediary who earned too much.

Some rays of light do emerge in the article though. The most interesting point in the article is as follows:

"An alternative suggestion is “narrow banking” combined with an unregulated (and unprotected) financial system. Narrow banks would invest in government securities, run the payment system and offer safe deposits to the public. The drawback of this ostensibly attractive idea is obvious: what is unregulated is likely to turn out to be dangerous, whereupon governments would be dragged back into the mess."

Not necessarily so. The narrow banking plus 'the rest' concept is worth greater consideration as it would make much clearer the distinction between risk and absence of risk. I would probably include regulated vanilla mortgages as assets in which the narrow system could invest. I also don't think Martin Wolf is advocating complete deregulation outside the narrow system - the 1933 and 1934 securities acts, and their foreign cousins would remain, as would the SEC, FSA and so on. In this structure, institutional failure would result not in 'socialised losses' but insolvency. Instead of regulating bankers' pay, show them some real downside, for this is what is missing from the present picture.

Edit: you have to read this. It is more eloquent than anything else I have read on this issue.