Managing Wall Street banker compensation
In the years before the crisis, bank executives made millions in short-term profits even when those profits turned out to be fleeting and the risky decisions the executives made turned out to be disastrous.
What was worse, many of these decisions amounted to leveraged bets. The upside was unlimited -- but the risks were also multiplied many times over.
One of the most overlooked parts of the new financial reform law holds arguably the most promise for changing how Wall Street behaves -- but it also could be among the most controversial if regulators try to use their full powers to dictate banker pay. (Don't bet that they will.)
In most ways, when it comes to banker pay, the financial reform bill is rather modest. It doesn't impose specific caps like those that faced some banks that received extraordinary financial aid from taxpayers. Specific requirements in the law include better disclosures about pay and more oversight by the boards of directors of banks.
But the secret weapon may be a requirement that regulators, within nine months, write rules for banks and other financial institutions that would prohibit pay structures that encourage excessive risk-taking.
If regulators are aggressive about this, their decisions about how pay on Wall Street should work could have as powerful an effect as any other new regulation contained in the financial reform law. That's because they'll be managing the incentives that bankers face in making decisions about risk. If they can better manage these incentives, they'll be striking at the human core of the financial system -- what motivates individuals to make choices about where capital should flow.
Recently, a number of noted scholars on compensation issues have been advocating a new approach to pay. Historically, the basis for incentive pay has been stock performance. In this model, a financial executive's pay, in the short term and long term, is linked to his or her company's stock price. In that sense, an executive's livelihood is linked to that of shareholders.
But as we learned in the financial crisis, a much broader category of stakeholders in a large financial firm are just as important to think about in designing pay structures. That includes preferred shareholders; bondholders; depositors; and even the government as guarantor.
To better represent this broad range of stakeholders, Alex Edmans and Qi Liu of the Wharton School at the University of Pennsylvania recommend that banker pay be tied to bonds as well as to equity.
We start with a model in which the CEO chooses between a risky and a safe project. The risky project can sometimes create value (e.g. investing in R&D) but sometimes destroy value (e.g. diversification from one's core business into derivatives trading, as with Enron and AIG). A CEO who holds only equity will take the risky project even when it destroys value because, if he gets lucky and it pays off, his equity will soar, but if it fails, it's bondholders who suffer most of the losses (as in the recent crisis). Equity holders' losses are capped by limited liability -- thus, if the firm is already close to bankruptcy and equity is close to zero, things can't get any worse and so the manager may "gamble for resurrection", taking riskier and riskier projects to try to salvage the firm. ... If the firm goes bankrupt, he loses his bonus regardless of whether creditors recover 80c in the dollar or 10c in the dollar. ...
Lucian Bebchuk, an adviser to the Treasury on compensation issues, argues for a similar model. But he advises that pay should be linked to the value of a bank's credit default swaps -- which indicate a probability that a bank will go bust.
Rather than tying executive pay to a specified percentage of the value of the bank's common shares, compensation could be tied to a specified percentage of the aggregate value of the bank's common shares, preferred shares, and all the outstanding bonds issued by the bank. Because such a compensation structure would expose executives to a broader share of the negative consequences of risks taken, it would reduce their incentives to take excessive risks.
Nevertheless, while such a compensation structure would lead executives to internalize the interests of preferred shareholders and bondholders, thereby improving incentives, it would be insufficient to induce executives to internalize fully the interests of the government as the guarantor of deposits. To do so, executive payoffs could be made dependent on changes in the value of the banks' credit-default swaps, which reflect the probability that the bank will not have sufficient capital to meet its full obligations.
In the end, these models, for all their intricacy, would achieve something simple: They'd make compensation less volatile. There would be less upside but also less downside. And that will probably mean less risk-taking and less innovation, but less danger of a serious financial crisis.
August 16, 2010; 1:22 PM ET
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