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 ‘wall street bonuses’
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.
If you have an interest in reading more about the Wall Street compensation issue, the Boston Globe published my op-ed piece today: please click 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.
There is no surer way to create unintended economic consequences than to regulate compensation plans. Connecticut’s Senator Dodd made a last minute contribution to the stimulus bill that places severe restrictions on executive pay for TARP recipients. As reported in the NY Times Dealbook Blog, one compensation consultant noted, “Any smart executive will (a) pay back TARP money ASAP or (b) get another job.” These new pay rules may well be the single worst part of the flawed stimulus package.
I spoke to an executive, a personal friend, at one bank that had been considering TARP funding. This is a well-managed bank that didn’t need the funds, but thought that it would be prudent to shore up their balance sheet in case the recession lasted longer than they anticipated. This additional capital would give them more flexibility and comfort in lending — indeed, they have been one of the banks in the forefront of making credit available in their area. My source said that at least in part because of the executive pay restrictions, they will now forgo TARP.
Senator Dodd’s restrictions will result in more firms avoiding TARP capital or repaying the TARP sooner than they would have otherwise. At the end of the day, this will mean less lending. More challenging will be the situation for firms which have no choice but to stay with TARP capital. These firms will be forced to either increase their executives’ salaries or provide compensation that falls well below market levels. The former seems politically unfeasible. If the latter, a “brain drain” is likely to result — a terrible outcome considering the taxpayers’ investment in these firms.
What’s the real risk of the flight of executives from these TARP recipients? The common counter-argument has been, “Who will hire these people? They ruined their firms.” This is simplistic and wrong. While CEOs and Risk Management chiefs certainly should bear consequences of their failures, many high-paid executives successfully ran business lines which had no connection to the disastrous choices of their colleagues. A quick perusal of the most highly compensated executives at Bank of America, for example, suggests that perhaps half had absolutely nothing to do with the balance sheet impairment that the corporation acquired courtesy of the purchase of Merrill Lynch. This isn’t to say that their pay shouldn’t be affected by their company’s fortunes. However, the company should certainly be able to have the tools to retain people like, for example, the head of IT, who surely is marketable to any number of corporations.
I’ve argued in a piece on Forbes’ website, that earlier regulations governing executive pay fostered Wall Street’s disastrous bonus culture. Corporate governance expert, Lucian Bebchuk, writes of the risks in the way Dodd’s amendments restrict variable compensation to stock awards. A list of similar examples of problems would go on and on. The bottom line is that companies need flexibility in setting compensation. Federal regulation of compensation is a pathway littered with unintended consequences, and has there ever been a “good” unintended consequence?
Disclosure: some of our clients hold positions in BAC, other financial companies and TARP recipients.
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.