Posts Tagged ‘executive compensation’
How Much Does the Financial Sector Cost?
Benjamin Friedman, in the Financial Times (hat tip Yves Smith), questions the high cost (read: compensation) of our financial sector. But he does not simply say that huge bonuses for bankers are unfair. Instead, he says that the costs of financial services need to be balanced against their benefits.
The discussion of the costs associated with our financial system has mostly focused on the paper value of its recent mistakes and what taxpayers have had to put up to supply first aid. The estimated $4,000bn of losses in US mortgage-related securities are just the surface of the story. Beneath those losses are real economic costs due to wasted resources: mortgage mis-pricing led the US to build far too many houses. Similar pricing errors in the telecoms bubble a decade ago led to millions of miles of unused fibre-optic cable being laid.
The misused resources and the output foregone due to the recession are still part of the calculation of how (in)efficient our financial system is. What has somehow escaped attention is the cost of running the system.
In particular, Friedman wonders at the relationship between the value provided by financial services and the opportunity cost involved: “Perversely, the largest individual returns seem to flow to those whose job is to ensure that microscopically small deviations from observable regularities in asset price relationships persist for only one millisecond instead of three. These talented and energetic young citizens could surely be doing something more useful.”
This reminds me of something Felix Salmon wrote about a while back: If profits and compensation in the financial sector go up and keep going up, that’s a priori evidence of inefficiency, not efficiency. Those higher profits mean that customers are paying more for their financial services over time, not less, which means that financial services are imposing a larger and larger tax on the economy. Now, it is possible that they are also increasing in value fast enough to cover the tax, but that is something to be proven.
By James Kwak
More on Executive Compensation
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.
Does the Administration Care About Executive Compensation?
They certainly want you to think they do. Yesterday was Executive Compensation Day in Washington. The Treasury Department appointed Kenneth Feinberg to oversee executive pay at seven companies that have received extensive government aid – AIG, Citigroup, Bank of America, and the car companies and their finance companies. The administration, which always seemed uneasy with the popular outrage over bonuses earlier this year, seems willing to throw the seven sinners to the wolves, while letting the bulk of the financial sector off the hook. Feinberg will only provide advice to other TARP beneficiaries, and banks that pay back TARP money will not even have to deal with that.
This, of course, solves precisely nothing. The problem with “executive compensation” – no, make that just “compensation” – in the financial sector was its structure. Huge end-of-year bonuses tied to short-term metrics, with no corresponding downside risk, motivated people to take on excessive risk in hopes of maximizing those bonuses. And the companies we need to worry about most are not the ones that are most beaten-down today, but the ones that are (relatively) the strongest and will be taking the biggest bets.
The Importance of Compensation
In my opinion, one of the biggest contributors to the crisis we know so well was compensation schemes that gave individuals at financial institutions – from junior traders all the way up to CEOs – the incentive to take massive bets. Put people in a situation where the individually rational thing to do is take lots of risk, and they will take lots of risk – especially if they are generally ambitious, money-loving, and predisposed to think that if the market is giving it to them, they must deserve it.
Alan Blinder does a good job explaining the problem in simple terms in the first half of his WSJ op-ed. However, I’m not optimistic about his solution:
It is tempting to conclude that the U.S. (and other) governments should regulate compensation practices to eliminate, or at least greatly reduce, go-for-broke incentives. But the prospects for success in this domain are slim. (I was in the Clinton administration in 1993 when we tried — and failed miserably.) The executives, lawyers and accountants who design compensation systems are imaginative, skilled and definitely not disinterested. Congress and government bureaucrats won’t beat them at this game.
Rather, fixing compensation should be the responsibility of corporate boards of directors and, in particular, of their compensation committees. . . . The unhappy (but common) combination of coziness and drowsiness in corporate boardrooms must end. As one concrete manifestation, boards should abolish go-for-broke incentives and change compensation practices to align the interests of shareholders and employees better. For example, top executives could be paid mainly in restricted stock that vests at a later date, and traders could have their winnings deposited into an account from which subsequent losses would be deducted.
Why am I not optimistic? Disney.
Two Things That Have Nothing To Do with Each Other
Data from Equilar (methodology), published by The New York Times:
I know this is simplistic, but I just couldn’t resist.
Some caveats:
- Stock total return is a poor way to measure CEO performance – yet it’s the one that CEOs and boards commonly point to to justify compensation.
- A CEO may have been granted a large stock award in 2008 as a reward for “good performance” in 2007. This could explain the combination of high compensation and poor 2008 performance. However, just think about what that means for a second.
- Most of the large compensation awards are largely restricted stock or stock options. These were valued as of the data of the grant, so if the company’s stock price later fell, the CEO is unlikely to realize the calculated value of the award. But imagine if the stock price had gone up instead: the CEO and the board would be insisting that the award should be valued as of the grant date, not the later exercise date (when it would be worth much more).
Also, I excluded a company called Mosaic, because it’s total return was 257%, so it packed all the other companies into one side of the chart. Mosaic’s CEO earned $6 million.
The Tipping Point?
$165 million, of course, is less than one-tenth of one percent of the total amount of bailout money given to AIG in one form or another. Yet it may turn out to be the $165 million that broke the camel’s back.
The AIG bonus saga neatly encapsulates many of the problems that we have identified with the financial system and with the bailout to date.
Here’s an Idea . . .
. . . since the Geithner-Summers team seems to be looking for them.
Why not say that all bank compensation above a baseline amount – say, $150,000 in annual salary – has to be paid in toxic assets off the bank’s balance sheet? Instead of getting a check for $10,000, the employee would get $10,000 in toxic assets, at their current book value. A federal regulator can decide which assets to pay compensation in; if they were all fairly valued, then it wouldn’t matter which ones the regulator chose. That would get the assets off the bank’s balance sheet, and into the hands of the people responsible for putting them there – at the value that they insist they are worth. Of course, the average employee does not get to set the balance sheet value of the assets, and may not have been involved in creating or buying those particular assets. But think about the incentives: talented people will flow to the companies that are valuing their assets the most realistically (since inflated valuations translate directly into lower compensation), which will give companies the incentive to be realistic in their valuations. (Banks could inflate their nominal compensation amounts to compensate for their overvalued assets, but then they would have to take larger losses on their income statements.)
We can dream, can’t we?
How Do You Like Them Free Markets?
By now everyone knows about this past year’s Wall Street bonuses: $18.4 billion total, the fifth-highest total ever; the $4 billion in bonuses rushed through by Merrill Lynch before its acquisition by Bank of America; and John Thain’s demand for a personal $10 million bonus (which was initially a demand for $30-40 million, according to Felix Salmon). This has, not surprisingly, unleashed a torrent of rage against Wall Street, up to and including Barack Obama, who called the bonuses “shameful.”
The usual defense of this sort of behavior is that you have to pay the market price for talent, the bonuses for top people are only a small fraction of the value they contribute (not a particularly good argument this year), and so on. And this is, not surprisingly, what John Thain was able to muster up in his defense on CNBC:
If you don’t pay your best people, you will destroy your franchise. Those best people can get jobs other places, they will leave. . . . you have to– pay market prices at the time.
Yes, there is a market for labor, and compensation is the price set by that market. And maybe it’s even a free market. But it’s certainly not a well-functioning market (one where price = marginal cost, for example, or where the surplus is divided between the parties, or where the right incentives are created).
