In the History of Scandal class that I taught in the mid-2000s, one of the lessons was that scandals have a life of their own, separate from the reality that they are nominally attached to, with the reality invariably being much less salacious than the stories that grew up around it. I have since seen the opposite phenomenon, as well–stories that could easily be made into huge scandals, but simply make the news one day to die the next.
In that context, I find myself asking, why isn’t New York’s attempt to outlaw Airbnb a scandal? The ban, and the now accompanying fines of thousands of dollars, is designed to restrict apartment owners from renting out their apartments to visitors. This has several obvious effects:
- Restricting the number of rooms available to visitors from out of town
- Making hotel rooms more expensive, so that the visitors that do come have less to spend on non-hotel items
- Preventing generally less affluent apartment owners from adding to their income (rich people don’t need to rent out their apartments to make ends meet)
But it should not be surprising that the bill was not called the “NYC Visitor Cap Bill,” or “Only Rich Visitors Allowed Bill,” or the “Ordinary Apartment Owners Don’t Really Need Extra Income Bill,” or the most honest title, “Government Supports Hotel Owners and Unions Bill.”
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The CEO Pay Ratio mandated by Dodd-Frank is finally here. The rule sounds simple enough: Companies must disclose the ratio of their CEO’s pay to that of their median worker. Interesting information, perhaps, but the SEC supposedly exists for a more lofty purpose than mandating nice-to-know data. It must, by law, act in the interests of investors. In fact, the Administrative Procedures Act requires the SEC to “base . . . decisions on the best reasonably obtainable scientific, technical, economic, and other information concerning the need for, and consequences of, the intended regulation.”
The CEO Pay Ratio rule is, indeed, of great interest to certain people. Union leaders believe that the rule will give them another crowbar with which to negotiate their members’ wages and benefits. Class warriors believe it will give them more ammo to shame corporations into reducing inequality. Fair enough. But the SEC does not normally allow itself to be used by unions for getting involved in labor relations, or by class warriors in anti-corporate crusading. So, why are they bothering with this rule?
Quite simply, because Dodd-Frank requires them to. The CEO Pay Ratio provision was inserted into the law, without debate, at the last minute by Senator Menendez. His rationale, explained after the fact, was, “This simple benchmark will help investors monitor both how a company treats its average workers and whether its executive pay is reasonable.”
How, exactly, will this “simple benchmark” help investors do those things? What number, or range, for this ratio tells an investor that a company is treating its average workers well or poorly, or that a company is paying its CEO reasonably (given that CEO pay is already thoroughly disclosed)? What economic or financial standards can be created using this or other data to enable investors to figure these things out?
As someone who has been asking this over the five years it has been debated, I can assure you that those questions have never been answered, neither by the rules proponents nor by the investors they claim to want to help. That’s because there is no logical basis for believing that the pay ratio can usefully inform investors either with regards to the company’s treatment of workers or the reasonableness of their executives’ pay. Consequently, there is no scientific or economic evidence that this ratio, alone or in combination with any other data, can be used to judge how well the company is being managed, or otherwise be related to company value—i.e., the nominal concern of investors. The Pay Ratio provides no more useful information than the ratio between the company’s highest cost office space versus its average cost of warehouse space, or between its highest cost commodity inputs versus its average cost of materials.
In other words, the SEC is simply being used in an experiment in social engineering. The expectation is that this ratio will shame boards into changing how they pay their CEOs. That goal might have some redeeming value if this experiment hadn’t already been tried, twice. The “shaming” theory was, in fact, largely behind disclosure rules enacted in 1992 and in 2006. A rational person would have looked at these and similar results, and decided it was time to try another hypothesis. Alas, it appears we are not dealing with rational persons. So today, ideology trumps science.
Paradox: a statement that is seemingly contradictory or opposed to common sense and yet is perhaps true
The media in Europe are starting to call skyrocketing banker salaries across Europe the “bonus paradox.”
The EU limit on bonuses to 100 percent of salary (or 200% with shareholder approval) is ushering a paradoxical parade of unintended consequences. But just because consequences are unintended doesn’t mean they are unpredictable.
The economic ignoranti fully expected overall banker pay to be clipped by the EU measure. José Manuel Barroso, president of the European Commission said, “This is a question of fairness.” So, there it is.
Except that banks are not going to lose their most mobile workers for insufficient pay. Bankers, you may not be surprised, are good with money; they know what they are worth, and they are confident about it. They would actually prefer to be paid for performance, and are unhappy about the higher mix of fixed-to-variable compensation that effectively caps their upside, even if it leaves them more-or-less whole in expected value terms. But they will not accept less than what the guy down the street, or in New York or Hong Kong, will pay them.
The more sophisticated proponents of this law would say that it wasn’t the level of pay they were actually after, but the structure of pay in the form of bonuses that encouraged undue risk taking. They’re OK with the new compensation mix, and feel it will reduce financial risk. They are wrong, too. Yes, it is theoretically possible that perverse incentives can lead to undue risk-taking, and there was certainly some of that going on in the lead-up to the financial crisis. But there is zero evidence that bonus structures that have been around for decades, and whose incentive effect have been understood and refined and overseen for decades, would all of a sudden in the middle of the aughts suddenly be the cause of a global catastrophe. If you want to properly diagnose a cause, look at what has changed, not at what was always there. If that logic doesn’t persuade, then perhaps empirical evidence would, and the evidence denies the hypothesis. If logic and empiricism don’t sway you…then you are fully qualified to run for the legislature.
Unfortunately we are not done with paradoxes and unintended consequences. Read more of this article »
The SEC has finally proposed a rule on the infamous “CEO Pay ratio,” i.e., the ratio of CEO pay to that of the median worker. There has been plenty of debate about the pros and cons of this requirement. The primary criticism is that this ratio will not pass any cost/benefit analysis. Every company knows this is true. Most institutional investors know it, too, and don’t really care for this rule. In fact, the only people likely to benefit from this rule are the unions that pushed for it. Even their benefit is speculative since the unintended consequences of this rule are difficult to fully predict. For instance, it might encourage further outsourcing of relatively low-wage work to foreign companies, depressing employment. In other words, we could very well see the average pay of the median worker go up, but only if you don’t count the zero wages being earned by those who are laid off as a result of this law.
Given how dubious are the benefits of this rule, let’s turn to the costs. I have seen estimates of calculating this ratio for a large, multinational firm as high as $7.6 million. Being in the advisory business, that seems pretty excessive to me. By comparison, the average cost of complying with the dreaded SOX Section 404 was about $2 to $3 million for the typical company (which was about 10 times higher than the SEC estimated it would cost when they published its rules).
So, let’s say it costs about $2 to $3 million for a large company, which is a reasonable estimate for a multinational given the way the rules look right now. Well, about 10 percent of Fortune 500 CEOs made less than that in 2012. That’s right, we are almost certain to see quite a few companies paying more than they actually pay their CEO to figure out how much more their CEO makes than their median worker.
If this rule was really being implemented for the benefit of the shareholders, then Congress could have let each company’s shareholders opt in or opt out of this disclosure regime. Clearly, the people pushing this ratio had no interest in giving actual shareholders a veto over this racket.
New, higher disclosure standards for executives
Imagine that one of your large customers, say you’re a supplier to Target or Whole Foods, wants you to disclose how much you and your senior officers make? You’re a private company, you may not even tell your kids or siblings how much you make, but these strangers want to know, and they want to place that information on the Internet. How would you feel about that?
Well, that is exactly what the Federal government is requiring of its contractors and sub-contractors via rules in the Federal Acquisition Regulation (FAR).
Actually, the WSJ headline was Europe to Limit Banker Bonuses. They also started the article with a tough sounding lead sure to please the politicians:
The European Parliament agreed to what officials described as the world’s strictest rules on bankers’ bonuses, capping big cash awards across the European Union in time for 2010 payouts.
Then you read the story itself:
The new law, agreed upon Wednesday, will limit upfront cash to 30% of a banker’s total bonus and to 20% in the case of very large bonuses. Between 40% to 60% of bonuses will have to be deferred for at least three years and can be clawed back if the recipient’s investments perform badly. At least half will have to be paid in stock or “contingent capital,” meaning it won’t be paid if the bank hits difficulties.
Hmm. This kind of looks familiar. Let’s see how Goldman Sachs was paying its executives before the crash of ’08:
The Named Executive Officers received bonuses in cash and equity-based awards in the proportion of 51% cash and 49% RSUs (restricted stock units).
Well, that wouldn’t quite cut it in Europe; they’re shy of the correct proportion by one percentage point.
Shares underlying all of these year-end RSUs granted for fiscal 2006 will be delivered in January 2010.
Ah, that’s more like it; the 49% of their bonus awarded in stock is deferred for more than three years, and is at risk of loss if the bank hits difficulties. Nice.
Now, let’s look at how Lehman Brothers was paying its executives before its collapse precipitated the financial crisis:
Annual Incentives were paid in the form of cash and RSUs. Messrs. Fuld, Gregory, Russo, O’Meara and Lowitt (the five named officers) received 88%, 85%, 64%, 70% and 70% of their total annual compensation in RSUs, respectively.
So, actually, Dick Fuld and company could only collect between 12 and 30 percent of their 2007 bonuses. The Europeans would go along with that!
All of the RSUs awarded to the executive officers for Fiscal 2007 are subject to forfeiture restrictions and cannot be sold or transferred until they convert to Common Stock at the end of five years.
In other words, the remaining 70 to 88 percent of their awards could not be collected for at least three years, and much more than half was paid in “contingent capital.” The Europeans would politely applaud.
So, according to the new EU rules, those cads at Goldman were, as usual, just barely outside the boundaries of correctness, while Lehman Brothers bonus plan was A-OK! Doesn’t that just explain everything?
The IMF is pushing for a bank tax:
[T]o pay for the costs of winding down troubled financial institutions, the IMF proposed what it called a Financial Stability Contribution”—a tax on balance sheets, including “possibly” off-balance sheet items, but excluding capital and insured liabilities. That tax would seek to raise between about 2% to 4% of GDP over time—roughly $1 trillion to $2 trillion if all G-20 countries adopted the tax.
On top of that, the IMF proposed that nations to adopt what it called a Financial Activities Tax, levied on the sum of profits and compensation of financial institutions. That would be paid to a nation’s treasury to help finance the broader costs of a financial crisis…
The IMF said that a nation didn’t need to put in place a specific resolution authority. Instead, the tax money could go to general revenues and used in case of financial crisis. But the IMF warned that the money would be spent by the time a problem arose.
OK, so let’s see how this would work. Congress levies massive new taxes on every major bank. Congress would then spend that money on…stuff. A financial crisis hits, and certain TBTF banks get into trouble. Congress bails them out, having to borrow gobs of money to do so because the tax revenues that were nominally for “Financial Stability” were in fact spent on…stuff.
So, how is this different from what happened last time? Hard to see. Does it do anything to reduce the systemic risks that regulators insist were at the root of the last crisis? No. Does it strengthen the banks to make them better able to weather such a crisis? Not likely when so much money of their capital–enough to raise between 2% to 4% of GDP–is being sucked out of their coffers. At least if the money were being held in a trust fund instead of dumped into general revenues, it would be there for frenzied politicians to disburse based on the rational workings of the government. But, of course, the money will not be there. It will have been spent not to support the financial system, but to support the reelection of incumbent politicians–the most short-term actors on the planet.
Oh. Yeah. THAT would be the difference.
So the lesson from all this appears to be: When it comes to a justify raising taxes, any excuse will do.
The Senate Banking Committee is now taking up the Dodd bill to re-make the financial services sector more into the image of how the government thinks it should be run, e.g., more beholden to Congressmen. Senator Menendez (D-NJ) offered an amendment to include disclosure of pay disparity, i.e., the ratio of CEO pay to the pay of the average (non-CEO) employee in the company. It’s clear that this amendment is meant to inflame passions about CEO pay, and nothing more. It won’t change what CEOs are paid because the premise behind this amendment, like so much else about pay regulation–that CEOs are paid arbitrarily high amounts–is wrong. CEOs are, on average, paid what the market says they’re worth, a law of supply and demand that Congress cannot rewrite or amend, only distort.
One of the many possible distortions that come to mind would be an increasing trend to outsource low-skilled (and, therefore, low-paid) help, either to temp or admin agencies, or overseas. That would help reduce that ratio. It would also help to bring in-house the employment lawyer who will have to make the silly legal distinctions between who is an “employee” for the purposes of this bill. Would a part-time worker be included? Interns? A lawyer skilled at such useless arcana would presumably bump up the average.
Hey, Senator, if you’re looking for useless ratios, why not mandate disclosure of the highest price product sold by a company versus its average priced product? Or something slightly more productive like the ratio of the highest tax versus the average tax jurisdiction they operate in?
HT: Broc Romanek
The U.S. Senate voted to charge $10 to visitors to the U.S. to promote…U.S. tourism. Really.
Lawmakers said many international governments aggressively help tourism in their countries by subsidizing promotional programs, but the United States leaves that work to the private sector and to state and local governments.
One might read this to say that the U.S. is looking to close the gap in freedom between us and the rest of the world by funneling more spending through Washington. But this tax would land on tourists, not Americans.
Which is why the EU is threatening retaliatory taxes on American tourists going there.
…in the war for global banking talent:
“Aggressive compensation systems – amongst many other factors – contributed to the financial crisis by creating false incentives,” BaFin said in a statement. “In future, short-term profitability must play no further role in the variable components of the compensation of managers and employees who can establish high risk positions.”
The commanding tone of this pronouncement makes one believe that they have a working definition of “aggressive compensation systems” and some proof that they contributed to the financial crisis. They don’t.
The most startling aspect of these new regulations is the claw back provision for bets that go bad:
“Variable components of compensation must also take into account negative future developments,” Lautenschlaeger said. “With this, risk takers are to share not just in the profits, but also in the possible losses.”
There is no distinction between whether the bets that led to those losses were good ones or bad ones at the time they were made, only whether or not they turned out bad. Consider the following scenario: A banker sees an opportunity to bet $100 on a project that has even odds of either doubling his money or losing half of it. He would be a moron banker to pass up this bet. The bank wants to encourage him to find these bets and make them. They have two choices on how to reward him. They can either reward him based on the expected value of the bets, i.e., $25 in this case, or they can reward him based on whether the bet actually succeeds of fails, i.e., plus $100 or negative $50. A reward based on the latter has a much higher cost to the bank since it must compensate the banker for the added uncertainty.
According to the new rules, the bank must adopt the latter, costlier scheme. They will have no ability to pay people bonuses for their expected value contributions if they must claw them back if good bets sour, as they often do in the business world. And that latter scheme has additional problems in the real world besides cost. In some cases it may be easier to estimate the quality of a particular bet than to know its actual result if the results of that bet get tied up into the results of other bets from the same book. In some cases, the results of particular bets, even if they can be tracked, may not be known for several years, possibly after the banker has moved onto another position. Delaying bonuses also significantly increases compensation costs since one must be compensated for deferring compensation. If you don’t defer the compensation, and you have to take it back later, then you have the logistical issue of recouping compensation already paid–in essence reaching into someone’s personal savings to get back the cash.
What did the regulator say to all these problems?
For the first time, Bafin has established provisions for clawing back money from individual employees if the deals they do turn sour. In so doing, Lautenschlaeger acknowledged that she had overridden concerns from the banks that such provisions are unworkable.
The English translation for Lautenschlaeger’s response begins with an “f” and ends in “you.”
Ironically, the banks’ reactions to these provision are almost certain to both increase the costs to the banks, and also reduce the alignment of their bankers. That’s what happens when you base prescriptions on the wrong diagnosis.
Depressingly, the reporting of this news has basically read like BaFin press releases.