History has proven that: whenever an individual, or a group of individuals, or a state has a Lettre de Marque to be above the law and do things forbidden to the rest, there is always a bad end to the story. In this case the same situation applied to banks and financial markets.

When on July 1, 2002 the International Criminal Court (Cour Pénale Internationale) concept began its works, the United States asked for a special treatment for US armed forces’ individuals, so that this court would not apply to them. The same situation took place when the time came to timely enforce Basel II rules to financial institutions; the US thought they didn’t need it, at least not right away.

Basel II risk management regulation focuses on sound institutional financial risk management. On a very personal note, I consider that had US financial institutions fully complied with Basel II regulation; the financial crisis burden for US financial institutions and may be the world, would have been very different. The special treatment for the US dollar following the 1944 Bretton Wood Conference, giving it direct gold convertibility, a situation that the rest of the world currencies did not have, had a very unhappy ending as well.

Now instead of focusing on complying with Basel II regulation, US authorities are focusing their energy in capping trader variable compensation. By doing this; it is being implicitly established that risk management derives itself from traders acting, and not the other way around. Establishing this implies that risk committees, risk managers, risk policies and risk limits either do not exist, or they are good for nothing.

In 1776 Adam Smith wrote in his famous work, The Wealth of Nations: “…It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.

The entire concept of free market economy works based on Smith’s ideas. Blaming the current crisis on greedy irresponsible traders has very serious consequences as it focuses on the idea that individuals are above institutions. It flirts with the idea that the risk management  function is either good for nothing or simply inexistent and is contrary to Smith’s ideas, and therefore contrary to modern market economy. Furthermore it diverts attention from the real problem of non compliance with international risk management institutional standards and will cause either mediocrity in the asset management function of financial institutions, or even worse: will increase the degree of trader frauds and in general trader related operational risk.

In the beginning of the twentieth century the US Office of the Comptroller of the Currency encouraged banks to pay reasonable compensation to their employees in order to avoid the risk of frauds and other type related situations; today it would seem that the idea is the other way around.

Capping variable trader compensation would have to come accompanied by a raise of the fixed compensation component which would disincentive adequate asset management strategies because traders would get paid equally, so why waste time and energy planning a better strategy, or on the other hand the trader will feel that he is not being adequately compensated and will seek various ways to finally obtain the compensation he thinks proper.

This situation has two main inconvenients, firstly, the only way the trader can access this money is through strategies which necessarily imply some type of fraud to the institution, and secondly, history proves that the trader will always get more this way from his institution than the traditional variable scheme, and we should not forget that in these last schemes, the government usually doesn’t collect any taxes from these transactions.

Finally as I was saying at the beginning of the article, efforts should be concentrated not in capping traders variable compensation, but in enforcing international, BIS established sound institutional risk management compliance.