If you cast your mind back to when executive compensation and bonus limits first reached the mainstream debate, you may recall people saying these would be ineffective and the issue is a red herring.
These points do not now seem compelling. People who work at the big banks are quite irked by what they see as unjustified limits on their bonuses. Some of the “talent” is jumping ship. Big bank leadership is lobbying hard to remove the restrictions or, failing that, for the right to pay back government TARP funds in order to escape the bonus cap – leading firms, such as Goldman Sachs, seem poised to raise new capital to that end.
This is a remarkable moment. Excessive risk taking in large firms was based on inappropriate bonus structures (take risk and get compensated now; face the consequences of that risk down the road), facilitated by a deep failure to understand/control risk inside these organizations and probably made possible by the implicit put option from being too big or too complex to fail (i.e., Wall Street insiders own the upside; taxpayer owns the downside). We have all focused of late on the costs for taxpayers, which of course are horrible, and going forward – with the implicit option now explicit – who can believe this will lead to anything other than further massive bailouts?
But think about this arrangement from the perspective of shareholders. Are we looking at the greatest tunneling scheme in the history of organized finance?
How can the large banks persuade potential shareholders to put large amounts of new capital with them, given that their systems just failed massively, these systems have not been substantially changed, and – while there has been a bailout for insiders and creditors – shareholders were largely wiped out from mid 2007-end 2008?
It could, of course, be the case that shareholders see great upside. Anything that has fallen greatly may see some rebound. The large banks have demonstrated their political muscle, so that should help with other forms of government protection and “rents” (economics jargon for easy money from business that others aren’t allowed into). In the early stages of a recovery, perhaps the banks will be more generous to their shareholders; it could be that the excessive tunneling is a feature of a mad boom, and we seem some distance from having another of those.
But probably we are looking at a deeper market failure. Big money managers – including mutual funds, pension funds and insurance companies -have arguably failed in their fiduciary duty to ensure that major financial companies are run properly and in the interest of shareholders. These money managers have great resources, many years of experience, and real power vis-a-vis the companies. Why didn’t they push for stronger risk management? Why are they so eager to hand over our money again? Where exactly was or is their due diligence?
Instead of shareholder activism being limited primarily to scrutiny of companies (where it often seems to bounce off, particularly if it comes solely from small investors), it should probably be focused more intensely on money managers, including why they are not more effective at limiting the bonus culture of big finance. Is this about their own bonus culture or their connections with the firms in which they are investing or something else? In particular, allowing large banks to also be major money managers creates serious potential conflicts of interest at many levels.
There is discussion of encouraging people to move deposits away from big banks with a pattern of bad behavior. But some of the most powerful banks rely relatively little on retail funding. More effective could be reassessing the practices of debt and equity investment funds, and placing money only with those that are beyond reproach.
It may be that the behavior of these money managers cannot be corrected through the actions of their small investors acting directly or through their employers (after all, our employers should have bargaining power over the funds that manage pension money). If we can’t sort this out through pressure, negotiation, and the market, perhaps money managers themselves should be subject to more specific legislation, implying greater regulation and sensible controls on their fee structure and strict caps on their own bonuses?