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Tuesday, May 15, 2012

Guaranteeing banker bonuses is an unintended consequence of pursuing Japanese model and higher capital standards

One unintended consequence of policymakers and financial regulators adopting the Japanese model for handling a bank solvency led financial crisis and pursuing higher capital ratios is guaranteeing banker bonuses.

Why does that happen?

First, under the Japanese model, regulators pursue policies like regulatory forbearance and suspension of mark to market accounting that allows banks to hide troubled assets on and off their balance sheets.

Second, under the pursuit of higher capital ratios, banks reduce their risk weighted assets by a) not making new loans (thereby subjecting the real economy to a credit crunch) and b) shedding their performing assets (those are the only assets the banks can sell without incurring a loss that would make it harder to reach the capital ratio targets).

In a short period of time, the quality of the assets on and off the bank's balance sheets deteriorates.  For example, the proportion of the loans that the bank is practicing 'extend and pretend' on becomes a greater portion of the total loan portfolio.

Third, the bankers get paid their bonuses based in part on the profitability of the bank.  A profitability level that the Japanese model keeps artificially high by design (under the Japanese model, regulators bless hiding losses).

Bottom line:  Bankers get bonuses based on non-existent earnings while the balance sheets of their banks become riskier.

I can understand why bankers like this, but why have policymakers and financial regulators signed on?

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