Bebchuk on pay

Posted by Marc Hodak on August 4, 2009 under Collectivist instinct, Executive compensation | 3 Comments to Read

Lucian Bebchuk is editorializing on compensation regulations again, proposing that bank compensation is too important to be left to the banks (or, more precisely, to their boards). Like any good debater, he attempts to address the objections put forth by critics of his position. I think he kind of stumbles on this one, though:

Furthermore, limiting structures that incentivise risk-taking is not more demanding in terms of information than regulators’ traditional intervention in investment, lending and capital decisions.

Not exactly a confidence booster, huh? (I’m visualizing the smart guys in Basel grinning nervously, asking, “Hey, what could go wrong?”)

Look, Bebchuk offers perhaps the best defense of certain proposed compensation regulations around. He is thorough, insightful, and moderate by the standards of current political discourse. In this case, he is not relying on his mistaken managerial power thesis to defend what he describes as a problem of externalities. But in the end, he makes the same error in assuming that developing optimal pay structures is something that anyone can do if they just think about it hard enough.

Developing good compensation mechanisms is not an exercise for amateurs. Even the experts get it wrong when they are acting in good faith. To expect a regulator, or any non-interested third-party to develop optimal compensation contracts for both the firm and society is like asking a committee of lawyers to develop a surgical strategy for treating leukemia; you know there’s a problem there, but it assumes the people you’re asking to solve it know what the right questions are, let alone the right answers.

I say, let the regulators show that they can regulate investment, lending and capital decisions–which at least have a basic theoretical ground of common understanding–before unleashing them on incentives, which can multiply the effects of unintended consequences.

Tags: i think therefore i can

Scott said,

He is thorough, insightful, and moderate by the standards of current political discourse.

Damning with faint praise?
David Scudder said,

The two principal problems which the regulators must resolve are lack of transparency and far too loose capital/leverage ratios. If no bank is allowed to have a conduit or SIV off balance sheet but must not only account for them but also reserve properly for the risk inherent in their assets, then a large step in the correct direction is taken. And if banks and investment banks must adhere to more strictly measured amounts of leverage on their balance sheets, then the other major problem is attacked. Compensation can and will resolve itself if the proper controls are put in place on activities which got the banks into trouble in the first place.

Personally, I am in favor of compensation schemes devised by top management, not foisted on an institution by government. However, I am also in favor of only paying out in a single year a portion of any employee’s bonus earned as a result of beating a particular index (i.e., for traders and the like). The institution wants to retain employee loyalty and provide as much incentive as possible for results which are truly long-term, measured over years not months. A scheme which credits an employee with a large performance based bonus, in my opinion, should also be set up to pay out only a percentage (perhaps 25-35% in the immediate year) with the remainder to be paid out over the succeeding 2-3 years, providing the employee stays with the firm and provided that the employee continues to beat an index.

This would not apply, however, to bonuses earned as a result of subjectively defined criteria, as opposed to objectively, performance based criteria. There, management should have the option of paying out a bonus when earned in its totality.
Marc Hodak said,

David,

Note that top banking executives have most of their personal net worth tied up in their firms. So it’s inconceivable that Blankfein, Mack, Dimon, or the others won’t have the incentive to limit comp induced risk for their underlings. That’s exactly why the compensation structures you’re proposing are exactly the ones beginning to be adopted–sans regulators–at the major financial institutions. (Goldman and JPM have historically relied on largely subjective factors, as I mentioned here: http://www.finreg21.com/lombard-street/the-radical-experiment-pay-regulation-under-tarp)