The government wants to fix compensation

Posted by Marc Hodak on June 15, 2009 under Executive compensation, Invisible trade-offs, Politics, Unintended consequences | Read the First Comment

The government, purveyor and practitioner of the most perverse incentives on the planet, is coming down the road with a cart of new remedies for incentive compensation:

“This financial crisis had many significant causes, but executive compensation practices were a contributing factor,” Geithner said in his statement on Wednesday. “Incentives for short-term gains overwhelmed the checks and balances meant to mitigate against the risk of excess leverage.”

It is, indeed difficult to pinpoint all the potential causes of the financial crisis, and it’s certainly plausible to point the finger at bank compensation.  The politicians and media would have us believe that:

A consensus has grown in Washington that compensation incentives based on short-term profit encouraged excessive risk taking at banks and played a major role in creating the financial crisis.

But the manner and degree to which bank compensation is at fault is, in fact, quite speculative.  We know this by looking at Mr. Geithner’s proposed guidelines, and the remarkable lack of empirical support that they get to the heart of the problem.  I have already commented on these guidelines elsewhere, so I’ll just mention something about the first point made in the linked article:

• Compensation plans should properly measure and reward performance. Compensation practices that set the performance bar too low or rely on benchmarks that trigger bonuses even when a firm’s performance is subpar undermines the whole concept of incentive pay.

The idea that one should not receive any variable compensation for “subpar performance” does not undermine the whole concept of incentive pay, it reinforces it.  The proposed guideline would simply truncate the range over which incentives are in effect.  Absent some replacement compensation, this guideline would reduce the ability of a firm to attract or retain talent.  The latter problem is easy to overcome; simply increase salary and reduce target bonus amounts.  But this remedy, which we are seeing adopted around Wall Street (and beyond), flies in the face of what one would consider good governance.

The other problem–the elimination of incentives at the point that performance goes south in any degree–is the salient characteristic of the traders option at the root of the bad behavior being blamed for the financial crisis.

Rather than deal with speculative factors for which a real remedy is difficult, why not first go after the obvious factors for which a remedy is at hand–the incentive to lend stupidly provided by government guarantees to the lenders?  The government could presumably do something about that.  What they have chosen to do instead is to double down on their folly, much like a trader that is in the red.

UPDATE:  Hot topic today.  Pretty good debunking of “consensus” claim.