I was surprised at the number of commenters on yesterday’s post who thought that executive compensation is a red herring or a political talking point or “populist pablum.” I agree that some of the outrage over compensation by TARP recipients is a bit overblown. But I also think that the incentives created by current compensation structures were a serious contributor to the financial crisis – which was, after all, largely about banks taking one-sided risks because of asymmetric payouts (lots of upside, limited downside) – and that fixing those incentives is an important task for regulatory reform.
So, I decided to call on some reinforcements. Lucian Bebchuk, a leading researcher of executive compensation (book; importat paper discussed here), and Holger Spamann have a new paper called “Regulating Bankers’ Pay” that discusses precisely this issue. They conclude not only that regulation of banks’ executive compensation would be a good thing, but that it may actually be better than the traditional regulation of banks’ activities.
Section II (PDF pages 11-28) lays out, with simple examples worthy of a Beginners post, what I thought was already generally accepted (but apparently isn’t): leverage, combined with the bank holding company structure, combined with compensation in the form of stock options, combined with deposit insurance, combined with the implicit guarantee on uninsured liabilities, creates large incentives to take excessive risks – defined as actions that have a negative expected value for the bank’s assets, but a positive expected value for bank executives. First of all, in a highly leveraged financial institution, shareholders already have the incentive to take excessive risks, because their downside is limited. This is amplified for executives holding stock options, whose downside is even more severely limited. Finally, explicit or implicit guarantees on liabilities reduce the incentive for creditors to adequately monitor banks’ activities.
As a result, Bebchuk and Spamann argue that executives’ incentives should be tied not to the value of shareholder’s equity, but to the value of all of the bank’s assets. Wait a second, though – isn’t the whole point of corporations that managers’ incentives should be aligned with those of shareholders? Yes, that is one consideration. But there are two other considerations that matter.
First, banks are unusual in that a large portion of their liabilities is guaranteed by FDIC deposit insurance, which already helps distort executives’ incentives as described above. As the insurer, the government needs to protect itself from moral hazard – and one way of doing that is reducing managers’ incentives to take actions that are good for shareholders but bad for the insurer.
Second, as we should now know, the incentive to take excessive risks, when shared across all the largest banks, is a major contributor to systemic risk. A systemic crisis leads to both government bailouts to protect non-guaranteed creditors, and to severe collateral damage for the economy at large. Therefore, the government should attempt to reduce those incentives, both to protect taxpayer money and to protect the economy.
Traditional regulation attempts to deter excessive risk-taking by limiting the set of activities that banks are allowed to engage in. Currently, however, bank executives have strong incentives to try to get around those regulations. In addition, Bebchuk and Spamann argue that regulators should at least monitor executive pay structures in determining whether safety and soundness risks exist. Ideally, they would link executive compensation not to the value of common shares, but to the aggregate value of common shares, preferred shares, and bonds. This would take away the incentive to take actions that have positive expected value for shareholders but negative expected value for the assets in aggregate.
The idea is that, in principle, it’s better to give executives the incentive to do the right thing than to give them the incentive to do the wrong thing and then try to hem them in with regulations.
Indeed, if pay arrangements are designed to discourage excessive risk-taking, direct regulation of activities could be less tight than it should otherwise be. Conversely, as long as banks’ executive pay arrangements are unconstrained, regulators should be more strict in their monitoring and direct regulation of banks’ activities.
Would the banks go for incentive compensation tied to the entire balance sheet rather than just common shares? It’s an interesting question. Under Bebchuk and Spamann’s proposal, they could still have enormous bonuses; from this perspective, it’s the structure that matters, not the size. But if the banks insist on tying their bonus packages to common shares, then we know that they are perfectly happy taking excessive risks. In that case, then this passage becomes particularly relevant:
In principle, well-designed incentive pay can improve the management of firms. . . . That being said, our analysis above identified major problems with the current incentive structure for bank executives. From this perspective, scaling down financial incentives may be a good thing. No financial incentives may be better than bad ones. Thus, if incentive compensation remains structured in ways that provide perverse incentives, limits on incentive pay can actually improve matters.
(On a related note, Marketplace and ProPublica ran a story yesterday on TARP recipients that figured out ways to give their executives golden parachutes.)
By James Kwak
The Baseline Scenario 
As I wrote at The End of yesterday’s blog comments, at present one is attracting The Wrong Mentality to the profession. Wall Streeters need to perceive their work as an important and sacred responsibility. At present they could care less. They have short-sighted and solipsistic mentalities. You are not going to “control” that. It’s like the problem trying to control a fusion reaction: it will pop out someplace else.
New kinds of people need to be attracted to the profession, with a greater understanding of the importance of serving. I suspect they will be, actually, much smarter and more competent than any of the over-sized egos sucking up money there now.
Jane Jacobs in her brilliant little Socratic dialogue book, Systems of Survival: A Dialogue on the Moral Foundations of Commerce and Politics lays it out quite clearly (although even Jacobs did not anticipate the present morass).
We will not succeed on the present path. The public will flock to the organization which models itself upon a “right” structure and compensation plan. The other lemmings and dumb turkeys will follow each other and the food.
A good incentive system must be hard to come up with. (Options, for example, were probably supposed to incentivize, but they turn out to promote huge risk taking, since if you win big you get big money, but if you lose big you don’t lose any more than if you lose small.) Instead, why not raise taxes, so as to minimize the monetary incentives and (relatively) maximize the moral/prestige incentives? I’ll have to lok at the bebchuk and spamann paper…
Well put, James.
One of the problems many have with any kind of market regulation is that they forget the major reason most of them are on the books on the first place: the economic damage wrought by past abuses. Instead – in no small part because the regulations performed their job of stabilization so well over the years – there is a tendency to see them more as (engine speed) governors rather than shock absorbers. (See Gramm-Leach-Billey Act – 1999) Those who argue that the free market will sort it out ignore the history that the sorting-out process has often resorted in great collateral damage.
The incentives don’t stop with just the top executives; the organization culture tends to reflect that of its leaders, with short-term, “take the money and run” incentives being the norm at all management levels. As the banks’ insurer on an ongoing basis, we the taxpayers have not only the right but the duty to demand the same responsibilities on the part of the insured that any other insurance provider might require.
The only thing that worries me a little bit is the on/off balance sheet stuff that also needs to get solved. It would seem that this might provide an incentive to keep risky assets off balance sheets and hidden. But we know about that problem already and should regulate it anyway.
As we look at the issue of executive compensation, we should also look at taxation. “As economy failed, perks rolled in- The recession bit nearly everyone last year, but for top executives, jets, ski condos, company cars and memberships at posh country clubs eased the pain.”
http://articles.moneycentral.msn.com/Investing/CompanyFocus/as-economy-failed-perks-rolled-in.aspx
Meanwhile, most Americans are cutting expenses to the bone and the federal government is considering numerous taxes on the consumer. For example a proposed tax on health benefits and recently, an article on federal taxation of cell phones. “The IRS wants to tax the use of cell phones issued to individuals as a fringe benefit.” http://www.dailyfinance.com/2009/06/12/irs-wants-to-tax-cell-phone-use/
Increased taxes should be across the board and the Ubers should pay a fair tax. I suggest a 90% tax on all earnings and perks above 10 million a year on anyone.
The Republican drive to cut taxes on the rich and shift the taxpayers’ dollars to the rich with no bid contracts and lavish war spending has left a huge hole in the budge. Their mismanagement of the federal budget has created a situation where the rest of must pay more. They should be taxed first in a sufficient quantity to pay the tax they should have paid before the huge tax breaks of Bush.
Their drive to deregulate and turn the economy over to the market God has caused a global meltdown that everyone must now pay for. It is time for the Corporations and the Ubers to pay their fair share. They benefited the most from the last 8 years.
Why not impose a 2% tax on all stock, bond, and commodity transactions. How about a business and occupation tax of 1-2% on the gross revenues of sales in the USA on all Corporations that do business here in the states?
Options were supposed to incentivize, and they did The problem is that they were the wrong incentives. This is an example of why someone outside the industry needs to be working on this issue. I don’t know if I would consider Geithner to be an outsider.
Raising taxes, in my opinion, is not going to help much. The perverse incentives will still be there. It’s a realignment of interests. In industries that are going to be supported by taxpayers, the interests of management should be aligned with taxpayers first, and shareholders second. Shareholders, after all, have a choice in the matter.
Incidentally, I do support a higher top tax rate. I just don’t know if it would do much to resolve this problem.
While the broader discussion of executive compensation is not a red herring, the specific discussion of limiting the compensation of executives of TARP recipients absolutely is. Just ask them:
Executives Unruffled by Proposed Compensation Rules
By Tomoeh Murakami Tse
Washington Post Staff Writer
Friday, June 12, 2009
NEW YORK, June 11 — Corporate executives breathed a sigh of relief Thursday after examining the fine print on broad new executive compensation rules and proposals put forth by the Obama administration
I am strongly against any legislative aim to curb or regulate executive pay in the private sector. You do bring up an excellent point with regards to the FDIC insurance of bank deposits, though. Wouldn’t a very nice way around this issue be to have the FDIC reimburse the individual whose money was lost on the condition that they not be allowed to redeposit it with that particular bank? This would then reinstate moral hazard restraints to banks.
One could envision banks colluding to take the same risks. Thus, when Banks falter and the FDIC reimburses individuals money would just be shifted back and forth between the Banks. However, I would feel that the most stable and profitable institutions would become the most attractive banks to do business with. Thoughts?
The above model is an exact description of reality:
“… leverage, combined with the bank holding company structure, combined with compensation in the form of stock options, combined with deposit insurance, combined with the implicit guarantee on uninsured liabilities, creates large incentives to take excessive risks – defined as actions that have a negative expected value for the bank’s assets, but a positive expected value for bank executives.”
The only other example the US economy has produced with such massive leverage is the public utility sector. There, a regulated and legally enforceable flow of cash — come hell or high water — from ratepayers to the utility was completely assured. The bond market understood the deal. For that reason, the utilities could run massively levered balance sheets, because, essentially, they were intermediating a stream of annuity payments from ratepayers to bondholders, who were financing the expansion of their asset base. What this led to was an incentive to expand the asset base, leading to often-necessary redundancy — think of the electric grid and generation infrastructure — and sometimes to overbuilding and waste. But overall, the slice of that cash stream the utility management could claim for its own enrichment was overseen by regulatory that fully understood what their role and responsibilities were — overseeing the buildout and maintenance of the utility infrastructure.
The banks, and now-former investment banks, bent the law and regulatory structure to create a full-faith-and-credit guarantee on total leverage — where once it was only an explicit guarantee to small savers leaving funds on deposit with them, so the banks could conduct the necessary intermediation of savings to investment. They transformed what was intended to be a utility-like backstop on a mundane process (intermediation of bank deposits) into a prop for massively levered risk-taking, which made them rich beyond their wildest imagining.
So, of course, they could minimize THEIR equity at risk, and convert that equity into a true call on total profitability. To be explicit, a convex payout (aka a call) on profits. At 30: to 40:1 leverage this was huge. They laid claim to all positive outcomes above zero $ of profit, in exchange for their minimal equity investment (aka “premium” in option-speak).
Year in and year out, they could up the ante and increase the bet and, since they were all doing it, asset values took off on a vertical trajectory. They were all doing the same thing, running the same no-arbitrage models, and bidding for the same assets. And, they had an extraordinarily accommodative Fed and regulatory edifice enabling all of this. It was delusional, and easily explained within the context of the models they all used — including the efficient-markets/minimalist-government theology economics had morphed into. But, as Kurt Godel demonstrated, a system is incapable of providing the proof of its own incompleteness, no matter how elegant. And, once again, we found the limits of a system of thought and belief that cannot step outside itself to prove its completeness.
Not to take anything away from the banks and former investment banks: Their behaviour was a brilliant and obvious outcome of banks’ ability to exploit advancements in financal theory that were every bit as significant as anything in bio-, micro-, nano-tech could produce. Options and derivatives theory has taken the mathematics of Brownian processes to levels never imagined in finance. Not unlike what physicists did for nuclear power. Physics got to the exploitation of the mathematics of randomness long before finance did, and gave us the whole suite of technologies we have routinized over the past 100 years or so — nuclear power, bio-physics, etc. Ultimately the banks were able to systematize this mathematics into new products and models of doing business.
What we’ve discovered, however, is that incompletely understood processes lead to uncontrolled reactions that are destructive beyond any experience anyone’s ever had. This is not some goofy metaphor: The banks and now-former investment banks are responsible for a level of destruction that would take multiple nuclear detonations around the planet to replicate (replication being a key aspect of the no-arbitrage world, not coincidently).
The thing that led the banks and us to this end was the fact that bankers were able to get so rich in the process of doing so. Every quarter, every year there wasn’t a totally destructive outcome, they were rewarded with more money than they could spend in 100 lifetimes. And, in the ultimate expression of not knowing what you don’t know, they all believed they were men (mostly) of genius, giants among us who had found a way to advance the evolution of perfect capital markets.
We’ve found one of many possible boundries of the financial universe. Our understanding is incomplete. Think about it.
I agree with others that regulating pay in the private sector is not the answer. However, what if one thinks about controlling the income at the corporate level. Is there a regulatory condition that could require significantly higher levels of some type of reserve or escrow of gains until they “pan out?” Not sure what this would be for investment bank, exactly, but surely something like this could be easily imposed as a condition for FDIC insurance.
The idea here is that if company does not “make” the money right away, it cannot pay it out to employees right away either. Management would be very loath to grant huge bonuses in advance of the earnings that justify those bonuses being released to them.
Thank you for pressing the compensation issue and delineating its significant importance. On a rudimentary level economics is about incentives and how people react to them, as you clearly outlined. But this is almost always lost on the genernal population in the imposing noise of financial and economic jargon surrounding any serious discussion of economic legislation. A major component of initiating the ‘political capital’ snowball you mention is educating the public about the existing perverse incentives, both public and private, that plague our economy and government. Serious reform must realign such fundamentals to serve the greater good.
A brief comment. Some of us think that executive compensation is a problem and also thing that the current hoohah is politics as usual. The administration has not shown itself to be serious about regulation of the banks. (Less so the previous administration.) Isn’t Summers one of the architects of the regulatory structure that helped get us into this mess? His presence sends a strong message: Don’t worry, guys, this will all blow over. Geithner talks about “the banks” when he means the too big to fail banks.
There is another question. Even if executive compensation is a problem, that does not mean that it should be addressed directly, nor, if it is addressed directly, that it should be done in terms of incentives. There is a downside to being too clever. Micro regulation leads to complexity, to the search for loopholes, and to lobbying for the creation of loopholes. Congressmen vote on measures that they do not understand, regulators attempt to enforce regulation that they do not understand, honest businessmen cross their fingers and hope.
I don’t see how the leaders at these firms can possibly believe that continuing a failed incentive program is the way to future growth and prosperity. Have they all gone mad on Wall Street?
I found an essay on VOX to be very informative on how the compensation/bonus structure came about – you can find that essay here:
http://www.voxeu.org/index.php?q=node/3602
Essentially, the move away from private partnerships to limited liability corporations “substantially reduces the incentive of senior management to monitor risk taking.”
As a solution, the authors call for exposing the senior most members of the company to the risks inherent in this kind of business – rather than automatically rewarding them regardless of how the company performs.
Found the piece to provide a valuable piece of the puzzle that is Wall Street.
Also, heartland populist that I am, I want to share one of the most outstanding incentive programs I’ve heard about – a true fusion of American ingenuity, money, talent and ambition. You can read about that program here:
http://www.chicagotribune.com/entertainment/chi-kanye-concert-kidsjun12,0,1049036.story
To sum it up: Some students at an affluent school in the Chicago suburbs were appalled by an NPR story of how hard it is to finish HS in the inner city of Chicago – so they organized a free show by Kanye West as incentive for students to stay in school and improve their grades/attendance records. 3000 kids were entertained by a local boy who hit it big (whose mother happened to be an educator.)
We need to use our wealth and ingenuity to come up with more programs like this….
Eliminating stock options seems brilliantly simple. The industry can easily substitute to paying in stock the fair market value of the options they would have granted, so it does not restrict the level of compensation, just changes the compensation to be more aligned with shareholder value with very little pain to anyone involved.
Is there any reason that current regulators cannot simply declare that options are not consistent with safe and sound banking practices since they encourage excess risk relative to readily available close substitutes?
As one of the readers pointed out yesterday, the easiest way to accomplish executive compensation is to
1. limit leverage
2. limit the size of banks
3. limit off-the-balance-sheet transactions and instruments
Then you don’t have to regulate anything related to pay. If banks have less avenues to make short-term fake profit (read: cause disaster in the long term), then they can’t pay generous salaries to traders.
What a nice post- thanks!
Just a small niggle- the appeal to Gödel is not quite accurate and is not, I think, necessary. The incompleteness theorems don’t say “no system can yield a proof of its own consistency”, they say “no complete formal system (with a certain laundry list of properties) can yield a proof of its own consistency.” Normal thinking, and even highly advanced academic thinking, is not a formal system, and so Gödel-type considerations don’t apply.
Trynig to apply Godel outside of the domain of mathematical logic is hard and not necessarily rewarding work.
That side, still a really nice post.
The problem is, I think, that it is very hard to make rules that don’t have loopholes or some way of gaming the system.
In a way this comes back to “the folly of rewarding A, and hoping for B”. In this case, we are rewarding executives for, excuse my French, screwing the tax payers/public, while hoping that they will act in the interest of the tax payers/public. The argument James Kwak is presenting is something like “instead of giving bank executives incentives to screw the public, then putting rules in place to stop them from doing it, why not remove the incentive to screw the public?”.
This seems like a very serious argument to me.
In light of the comment I just made, perhaps a link to Steven Kerr’s classic paper (“On the folly of rewarding A, while hoping for B”) might be useful, as presumably quite a few have not read it, and it’s both topical and fun:
Click to access rewardingA.pdf
Point taken. Thank you.
While this seems all too easy to an outsider, any attempt to re-align compensation incentives will be met with fierce opposition from the financial industry. The reason is simple; realigning incentives will greatly reduce the justifiable compensation for the financial executives because it will reduce the industry’s profits. The current system allows executives and shareholders to pursue greater profit through greater risk, knowing that the taxpayer and/or economy are bearing much of the real risk. If risk is reduced or shifted to the industry, profits will suffer and it will not be possible to justify such large compensation. The industry will view this as a fight for their survival, much as the UAW viewed labor disputes in the not too distant past.