Regulators have an enormous challenge ahead. It’s relatively easy to formulate rules that will prevent a repeat of this specific crisis. However, it is unlikely that Wall Street would make the identical errors in our lifetime. The regulatory reformers are charged then with two major tasks: 1)preventing the type of mass loss of judgment which we saw, and 2) should that fail, limiting the damage done. Both are dismayingly complex, but the more the first can be accomplished, the less the second will be needed.
There’s no doubt that the compensation system of Wall Street played a role in bringing about the Panic of 2008. Regulators seeking to prevent the next crisis of systemic risk must address Wall Street’s bonus culture. Salaries are an extremely small portion of the total compensation of even mid-level managers at these firms. I knew many $1MM+ earners whose salaries were less than 15% of their total comp. This orientation to “performance pay” skewed employees towards risk-taking, particularly because the easiest metrics were financial measures — profitability prime among them. Employees were paid for immediate financial results, not long-term prudence. This created an incentive to “swing for the fences” in risk-taking, particularly since it was the shareholders’ capital at stake, not their own.
Various firms have sought to incent longer-term thinking by including restricted stock and stock options in the compensation mix. While this has some benefits, employees still are biased to what puts money in their pockets short-term, so more innovation is needed. UBS has taken a stab at correcting this problem by deferring portions of employee bonuses and tieing them to future consequences. A bonus earned this year might be lessened by results next year. While there are numerous deficiencies to this approach, it is a step in the right direction, and one worthy of praise.
The real challenge is to get universal industry buy-in to such an approach. Otherwise, firms trying to rein in compensation will simply lose their best employees to less responsible firms. Intra-industry cooperation risks charges of collusion, so this may be an area where regulators must take the lead.