This afternoon MarketWatch published an article I wrote that applies the classic game theory problem of “The Prisoners’ Dilemma” to Wall Street’s bonus culture. Read the article here.
Posts Tagged ‘executive compensation’
Two headlines this week caught my eye and suggest that at least some reforms in the financial industry may not improve the lot of individual investors.
Earlier this week, the Wall Street Journal carried a story, “Stock Research Reform to Die,” which discussed the end of the requirement of Wall Street firm’s to carry independent research. The general tone of the piece was to highlight how little it was used by clients and advisors, citing for example a statistic that showed only 11.5% of financial advisors were using the non-proprietary research at least occassionally. The analysis misses the actual importance of the research — given that the vast majority of financial advisors are no longer stock-pickers and use managed money instead, that 11.5% likely represents a very high percentage (half?) of advisors who actually select individual equities. There is a legitimate argument that could question the cost-effectiveness of this reform, but individual clients and their advisors will be worse off as the requirement expires and several firms stop providing the research. Kudos to Morgan Stanley Smith Barney for continuing the practice despite the cost.
On another front, in today’s Wall Street Journal comes news that the administration will be addressing compensation structure throughout the financial services industry. To the administration’s credit, these will be issued as “best practice” guidelines rather than inflexible rules (at least for those firms not encumbered with TARP). According to the article, the administration will focus on guidance that bonuses be largely structured as restricted stock in an attempt to align employee and shareholder interests. While I sympathize with those who see flaws in the bonus structure (see, for example, my op-ed in the Boston Globe from March), restricted stock awards carry their own problems.
Requiring a heavy emphasis on restricted stock has been favored by many academics. In some cases, these are even some of the same people who proposed the unsuccessful executive pay reforms in 1993 that actually contributed to the current problems. Focusing on restricted stock awards may be an effective strategy for many industries, but is ill-suited for a financial service industry that has an ethical and often legal responsibility to it’s customers.
In a meeting I attended over 20 years ago, Joe Grano, then the head of PaineWebber’s private client group, shared wisdom that has stayed with me: “In our industry, everything we do has to be a fair balance between our responsibilities to the client, to employees and to shareholders.” Skewing compensation further to restricted stock can place an undue weight on shareholder interests to the detriment of client needs. At a previous employer with a strong (forced) orientation to employee share ownership, I saw this at work first hand. In the ethical election poll, the vote for employee compensation now gets aligned with the vote for the shareholders, with the client left in a lurch. Over the years this surely contributed to Wall Street’s past sins of proprietary product pushes and research tainted by investment banking profits. This is an industry, after all, which often thinks of its financial advisors as “distribution,” serving the needs of the “production” created by investment banking and product creation groups.
Setting aside the adverse consequences for the clients of these firms, I do not believe the restricted stock requirement will even have the desired effect of reducing systemic risk. This is really a game theory question and a variation on the famous “Prisoner’s Dilemma,” where suboptimal results are driven by individual perspectives. The Wall Street traders who helped create the systemic risk didn’t intend to destroy their firms, after all. It would be easy, from the perspective of an individual trader, to assume that any colleagues are simply trying to maximize their own bonuses and taking on firmwide risk, so they might as well get what they can, while they can. Essentially, the thought process will be: “I can’t control the share price or overall firm performance, all I can do is maximize my own bonus whether it is paid in cash or stock.” In terms of risk taking, that puts us right where the industry has been all along, only now there’s an additional rationale to overlook the client interests.
It’s important that our financial industry’s systemic risk issues be addressed, but the burdens of the necessary reforms shouldn’t be carried by the clients of the industry, the individual investors.
Reuters and other news services report that Goldman Sachs CEO Lloyd Blankfein, during a speech before the Council of Institutional Investors, weighed in on the need to reform Wall Street’s pay packages . Obviously, this is an issue I’ve written about quite a bit (with pieces in Forbes, the Boston Globe, and Marketwatch) — it is great to see a major Wall Street executive showing some leadership on this issue.
With regard to pay, Blankfein calls for a number of reforms: 1) greater percentage of compensation in company stock with a multi-year vest, 2) Bonuses that recognize not just the profits earned, but the risks taken, and 3) evaluating whether compensation-driven incentives “work against the social good.” While I think these are steps in the right direction, I would prefer to see this driven through Wall Street’s self-regulatory structures; Blankfein seems to suggest that legislative action is needed. Legislative solutions lack the flexibility to deal with future circumstances and become hostage to political whims.
From my own experience, I’ve seen that a high percentage of stock ownership (item #1 above) may conflict with broader needss (as in item #3 above). Wall Street has greater responsibilities to its customers than many businesses. The industry works best when it achieves a balance between the interests of shareholders, employees and customers. An undue emphasis on share performance can lead to short-changing the customer. A great example of that was the corruption of research by investment banking in the late 90s. Good for the employee (bonus), good for the shareholder (earnings), but bad for the client who relied on the tainted research. Reforms discussions need to consider raising the salary component of compensation, and removing tax code impediments to this approach. This would make compensation costs transparent to shareholders, encourage broader thinking and risk assessment on the part of employees, and serve clients better. On the other hand, it is unlikely that, under such a pay regime, Mr. Blankfein would have another year like 2007 when he earned $70.3 million. I wonder why he didn’t bring that up in his speech?
By way of ancestry, I’m genetically designed to be plowing some field in Eastern Europe. This lends itself to a certain stubborness of personality. I’m not quite ready to let go of my belief that Wall Street’s self-regulatory organizations should be stepping up to the plate and addressing the destructive compensation practices of the industry. MarketWatch published a piece I wrote on this topic.
Please read, “Memo to Wall Street: America Hates You”
I caught this post on Greg Mankiw’s terrific blog. The following resignation letter from one of the bonused executives at AIG appears in today’s edition of the NY Times. I’ve written quite a bit about Wall Street compensation, on this blog, for Forbes and in Friday’s Boston Globe. The issue is poorly understood by the media, has been demagogued by politicians, and is understandably misconstrued by the public. The bottom line has always been that talented people command higher compensation (although the tax code has amplified and distorted Wall Street’s pay structure). Arbitrarily cut the compensation and you lose the most talented people:
DEAR Mr. Liddy,
It is with deep regret that I submit my notice of resignation from A.I.G. Financial Products. I hope you take the time to read this entire letter. Before describing the details of my decision, I want to offer some context:
I am proud of everything I have done for the commodity and equity divisions of A.I.G.-F.P. I was in no way involved in — or responsible for — the credit default swap transactions that have hamstrung A.I.G. Nor were more than a handful of the 400 current employees of A.I.G.-F.P. Most of those responsible have left the company and have conspicuously escaped the public outrage.
After 12 months of hard work dismantling the company — during which A.I.G. reassured us many times we would be rewarded in March 2009 — we in the financial products unit have been betrayed by A.I.G. and are being unfairly persecuted by elected officials.
Read the rest here.
Two recent pieces in the Wall Street Journal add credence to the dangers of government interference with compensation arrangements. In today’s edition, there’s an article highlighting the departure of key investment bankers from their firms. Many are joining boutique firms to avoid the public scrutiny of their compensation arrangements that has come with government involvement. This is a slow death for these firms — those rainmakers who do have career alternatives are usually the strongest performers.
The politicization of Wall Street paychecks is impacting the ability to fix this mess as well. In a February 24 op-ed, William Isaac, the former head of the FDIC who took over Continental Illinois, notes that one of the reasons nationalization is not a viable strategy today is because pay restrictions complicate the manpower issue, “We had significant difficulties attracting quality people to Continental even without today’s limits on compensation.”
Demonizing Wall Street’s high earners may make for great headlines, but at the end of the day, it will make for a poor return on our taxpayer investment in these financial institutions. There are other areas where we accept that top performers can make good money even when their organizations are suffering: high-paid actors in flop movies (Warren Beatty and Dustin Hoffman in Ishtar each earned $5.5 million), star athletes on mediocre teams (Vince Carter of the NJ Nets earned $18 million in 2007). Surely it is no more ridiculous to pay star investment bankers who help raise capital and provide strategic advice for the nation’s businesses. The worst outcome would be to see these businesses bled to death by an exodus of money-making talent.
It’s an ugly truth that we’ve needed taxpayer involvement in the financial institutions. No matter the necessity, just like fish and visiting in-laws, this situation does not age well.
At the Wall Street firms where I’ve worked it was often said that, “the assets of the company ride up and down the elevator every day.” This adage recognizes the critical role that individual talent plays in the financial services industry. President Obama’s new restrictions on executive pay are largely symbolic, but to the degree they do impact firms, they will serve to deplete their human assets, driving the most skilled individuals to other firms. As a taxpayer, I want the most talented people to be running the firms which are TARP beneficiaries. Compensation restrictions will tend to push those people to firms that can offer more attractive remuneration packages.
Wall Street’s emphasis on bonuses is stupid. As others have noted, Wall Street views bonuses unlike any other industry. There are few, if any, industries where the majority of decision-making employees can expect bonuses that are in excess of their salaries, often by a factor of several 100 percent. This drives some very odd behaviour that may serve the annual bonus pool, but does little for long term shareholder value or for customers. This is particularly damaging when the most senior executives are tied to this structure.
So why has this system persisted? The answer lies in the tax code. Efforts to curb executive compensation in the early ’90s pushed compensation to be far more bonus-oriented through limitations on the deductibility of salaries (but did not limit other forms of compensation).
Wall Streets bonus culture is a result of excessive regulation. President Obama’s move to impose further restrictions and rules is a step in the wrong direction.
Forbes published an article of mine with more details. You can read it here.