Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Structure of the compensation

People also raise serious concerns about the structure of bankers’ compensation. In financial services, employees are commonly paid a base salary (which on its own would be considered generous to most people) supplemented by a bonus, which for high-performing staff can be many multiples of the base salary.

multiples of the base salary.


This structure has been blamed for creating a whole new level of moral hazard inside a financial institution. Even if a bank’s senior managers do want to do the right thing and not take excessive risk (that is, not take advantage of the fact that they’re too-big-to-fail and that the government can’t fully see their actions), those senior managers can monitor only imperfectly the actions of the bankers under them. This arrangement gives bankers almost irresistible incentives to take on risk.

Here’s a simple example. Imagine that you’re responsible for trading currencies for a bank and that you haven’t the foggiest about what’s going to happen to the value of the pound in the future: it might go up, it might go down, who knows. Nevertheless you reason that if you take a big bet that the value of the pound will go up and it does indeed go up, you’re in for a nice fat bonus. If you’re wrong, and the pound falls, probably, the worst that happens to you is that you lose your job.

The moral hazard problem here is clear: taking on lots of risk has huge upside potential but limited downside. Banks are aware of this issue and have risk-management departments meant to ensure that no one is taking on too much risk on behalf of the bank. However, because monitoring people’s actions is difficult, they have a tough job on their hands. Furthermore, seeing the true impact of a complex deal for a bank can take years, by which time the employees responsible may no longer even work there.


Jérôme Kerviel and SocGen

Jérôme Kerviel was a trader at French bank Société Générale (SocGen) who took on massive risks and ended up losing the bank €4.9 billion(!). This enormous loss almost brought SocGen, one of France’s largest banks, to its knees.

Kerviel joined SocGen’s compliance department in 2000. The role of a bank’s compliance department is to attempt to ensure that the bank and its employees operate within the law and follow all the relevant rules and regulations. The assumption is that Kerviel gained a good understanding of the internal working of the bank, which later helped him cover up his risk-taking activities.

In 2005 Kerviel was promoted to the role of a junior trader, where his job was supposed to be taking advantage of the mispricing of shares in companies (a supposedly low-risk activity). But Kerviel actually placed very large bets on the stock market (estimated at around €50 billion, more than the value of the entire bank!). You’d have thought someone would’ve spotted such a large amount of money being played with, but the bank claims to have noticed his activities only in 2008, by which time he’d accrued billions in losses.

In 2010 Kerviel went on trial and was found guilty of ‘forgery and breach of trust’. Initially, he was sentenced to five years in prison (with two years suspended) and ordered personally to repay the full €4.9 billion (not likely!). In 2012, on appeal, Kerviel’s sentence was reduced by two years (so that he’d serve only one year in prison), and ultimately in 2014 a French court ruled he wouldn’t have to repay the €4.9 billion.

The Kerviel case is an extreme example of a general principle: the way people are paid in financial services can incentivise them to take excessive risks, because the potential rewards if things go right seem relatively large and the potential costs (to them) if things go wrong seem relatively small. Kerviel’s bets went sour, of course, but had they gone his way, most likely the media would’ve taken no interest and he’d have been rewarded with a substantial bonus.