Why is Canada breaking ranks on bankers' bonuses?

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Canada likes to think of itself as the country that emerged from the financial crisis squeaky clean. Too bad it is abdicating a leadership role in creating a safer financial system going forward.

The issue is bonuses paid to top executives in the financial sector. It looks like the Europeans and Americans are pushing for consensus at the upcoming G20 meetings to adopt limitations on these bonuses. But Canada is poised to be the spoiler.

What is the fuss about bonuses? This issue surfaced in the aftermath of the financial crisis as experts sought to understand how the financial system could go so wrong so fast. Why were so many iconic financial sector firms involved in reckless activities that culminated in such a huge mess?

One factor in the noxious brew concerns executive compensation. In economics lingo, the prevailing executive bonus system can create a perverse incentive. Financial rainmakers get large bonuses when they generate high profits. These high profits tend to go hand-in-hand with heightened risk exposure. So by linking bonuses to short-term profits, executives are encouraged to juice up their pay packages by exposing their firms to elevated risks. These risks might go sour at some point. But the bonuses are paid soon, and the bad risks may only start exuding a foul odour later.

After all, the financial whiz kids don't have to give back the bonuses if it turns out that they were paid on the basis of profits that later self-destruct. And many financial executives will have moved to other positions by the time the powder-keg blows, so it is somebody else's problem to clean up the mess later.

This perverse incentive at the heart of current executive bonuses is why U.S. Treasury Secretary Timothy Geithner concludes that "compensation reform is a necessary part of building a more stable system."

But if this important aspect of financial reform is going to work, all the G20 countries must stick together. If one country lets its financial sector pay any sort of bonuses, this will create a haven for the questionable practices that these bonuses encourage. Financial executives in countries that curb bonus practices will threaten to leave for more compliant jurisdictions unless their home governments change the rules. Ironically, even financial sector firms that worry that these bonuses will bring tears later will be pressured to lobby officials to relax bonus rules for fear that their talent will leave for the regulatory wild west.

So consensus among the G20 is critical to making the new bonus limitations work. As British Treasury Minister Stephen Timms insists, "We can't have different countries played off against each other on the question of banker's bonuses."

Thus far it seems that Finance Minster Jim Flaherty seems ready to break ranks on executive bonuses -- thanks in large measure to the persuasive powers of the Canadian Bankers Association who think that decisions about executive compensation should remain with banks' boards of directors. According to a published report, Flaherty will handle the bonus issue by asking the Office of the Superintendent for Financial Institutions to take pay practices into account in its regular reviews of banks. This mild promise does nothing to conceal that our finance minster has failed to put his foot down.

If Canada refuses to sign on to this proposal, it signals that Canadian financial regulators are less serious than their counterparts elsewhere in curbing the excesses produced by short-sighted bonus schemes. It would be a bitter irony if Canada compromises the reputation it earned in the last financial crisis by putting out the welcome mat for the kinds of dubious activities likely to promote another financial crisis.

 

Ellen Russell is a Senior Research Economist with the Canadian Centre for Policy Alternatives.

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