The discreet charm of other people's money:James Saft

-- James Saft is a Reuters columnist. The opinions expressed are his own --

By James Saft

LONDON (Reuters) - If you get paid for hammering, everything looks like a nail.

One of the clearest lessons of the debt market debacle is how poorly constructed and dangerous many compensation arrangements in financial services are.

In short, a lot of people have made a lot of money in recent years taking risks with assets that do not belong to them, taking a hefty share of the profits if bets pay off but not sharing equally in the losses.

What to do about it is, of course, a lot less clear.

"Banks have come to realize in the recent crisis that they are paying the price for having designed compensation packages which provide incentives that are not, in the long run, in the interests of the banks themselves, and I would like to think that would change," Bank of England Governor Mervyn King said in an appearance before lawmakers last week.

For a good example, look no further than UBS's (UBSN.VX) recent mea culpa on how it clocked up $37 billion of writedowns. It details how its employees could use UBS's very low cost of borrowing, buy risky assets like subprime and be credited with creating value.

"Incentivization arrangements did not differentiate between return generated by skill in creating additional returns versus returns made from exploiting UBS's comparatively low cost of funding in what were essentially carry trades," the report said.

Nor, according to the report, did pay policies take sufficient account of protecting the bank's long term prospects or even the longer term impact of trades. In other words, make a trade that you can only execute because of the bank, see its notional value go up, get paid, and if it then goes bad at worst you get fired, but thankfully you've already got your bonus.

To be fair to UBS, there is not a lot of evidence that policies there were wildly different than those at many other banks.

Look too at a recent study of hedge fund behavior by Nick Motson and Andrew Clare of Cass Business School and Chris Brooks of the University of Reading.

Hedge funds make most of their money by sharing in the gains of their funds, but only if they clear certain hurdles. The study, which analyzed results of 2,800 hedge funds operating in a 13-year period, found that hedge funds took on far more risk when their funds were substantially below the point at which their incentive fees kick in.

It's a bit like betting more on the last race of the day at the track to make up earlier losses, but with the crucial difference that it is not your money if it is lost, but you get to keep some if you win.

Nick Motson stresses that the data is preliminary and requires more investigation, but human nature being what it is, it has the ring of truth.

A DOG BITES MAN STORY

This is not a new problem, nor is it one unique to financial services. Human beings exploit systems, working out their own best advantage and playing to it.

But the scale of the rewards in finance are so huge that the thought of losing one's career, the usual ultimate penalty, might not outweigh the lure of getting rich if you can get away with it. Secondly, at least when it comes to commercial banks and investment banks, it is very clear that public money is at stake when things go bad.

That theoretically gives regulators a say over how banks and investment banks pay their employees, as well as a motivation to worry about a system that might encourage risk taking by those employees who by definition haven't got the resources to make good the costs if things go bad. Thus the traditional argument that compensation issues are shareholders' look out and not an area for regulation doesn't really wash.

For hedge funds it is more complex. They have sophisticated clients such as funds of funds, who increasingly are demanding and getting insight into how they operate. Motson for his part sees virtue in having a hedge fund manager put most of his own wealth in a fund, thus aligning interests. There may also be scope for instituting longer term payouts, both for hedge funds managers and bankers.

I am not particularly optimistic about the ability of the authorities to square this particular circle, but I think they may well try.

Even without government intervention, financial services firms will want both to harness their employees' efforts better, and to be seen to be doing so.

But some day, probably soon, another area of banking and finance will get hot and as it does, look for competition for talent to loosen up whatever the new sobriety brings.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund --

(Editing by Ruth Pitchford)

(+44 207 542 2734. Reuters Messaging: jim.saft.reuters.net@reuters.com))