Germany surrenders…

Posted by Marc Hodak on August 17, 2009 under Executive compensation, Reporting on pay, Stupid laws | Read the First Comment

…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.