“It’s Not How Much You Pay, But How”

Posted by Marc Hodak on May 28, 2009 under Executive compensation | 3 Comments to Read

Finally, a sensible editorial on banking compensation. Alan Blinder waves away the misdirection associated with “how much” bankers have been paid to identify the critical element of “how” they’ve been paid. The answer, as my loyal readers know, is the infamous trader’s option and the trader’s supervisor’s option.

Darwinian selection ensures us that these folks are generally smart young people with more than the usual appetite for both money and risk-taking. Unfortunately, their compensation schemes exacerbate these natural tendencies by offering them the following sort of go-for-broke incentives when they place financial bets: Heads, you become richer than Croesus; tails, you get no bonus, receive instead about four times the national average salary, and may (or may not) have to look for a new job. These bright young people are no dummies. Faced with such skewed incentives, they place lots of big bets. If tails come up, OPM will absorb almost all of the losses anyway.

Blinder suggests what I would consider timid, but sensible reform directed at exactly the right place–the board of directors.

The thing we have working against us is incredible, but understandable conservatism on the part of shell-shocked boards that truly can’t distinguish bold, good mechanisms from bold, schlock mechanisms. I know where they’re coming from. I feel the same way about macroeconomists as I try to get a handle on what’s going on. The thing we have working in our favor is that, the top executives at even public companies actually have a lot of skin in the game, and it’s not just upside. Dick Fuld and Jimmy Cayne didn’t actually want to end up the way they did. If they had any idea of the risks they were actually enabling, they would have looked for a better way. Their surviving competitors are not dummies.

Extra credit for the compensation mavens reading this if they can identify the irony in the title, which was actually coined nearly 20 years ago.

Kat said,

Alan would like to lay this all at the feet of the traders and investment bankers. The reality is that when Stan O’Neil decides that Merrill is going to be the 800 pound Gorilla of subprime mortgage CDO & CMO underwriting, then the traders and the bankers don’t have much choice in the matter. Top management is constantly pushing for the development and trading of more products – especially derivatives – regardless of how poorly those products are constructed.

I’m sure you understand the problem you run into if management requires risky behaviour but then forces the traders to eat all the losses when they engage in risky behaviour. Smaller trading concerns I’m familiar with tend to compensate based on risk adjusted returns because it’s easier to match the two when you’re not aggregating risk management in a central location or when there are relatively few traders. But at larger firms, it gets harder and those firms don’t want traders swinging for the fences to begin with. The problem starts way before you get to the traders and their compensation. It starts with the CEO.

Incidentally, somebody should tell Alan Blinder that while these people receive base comp equivalent to about 2-3x (not 4x) the national average, they all live in a part of the country that is 4x more expensive than the national average. Liberals always forget to account for such things when they moan about compensation.
TRUTH ON THE MARKET » Revisionist corporate governance said,

[…] The op-ed has been cited favorably by commentators ranging from the predictably-tiresome-and-unlikely-to-know-better (Frank Pasquale) to the informative-but-reflexively-pro-regulation (James Kwak) to the always-interesting-and-not-normally-in the-company-of-the-likes-of-Frank-Pasquale (Marc Hodak). […]
Revisionist corporate governance « Truth on the Market said,

[…] The op-ed has been cited favorably by commentators ranging from the predictably-tiresome-and-unlikely-to-know-better (Frank Pasquale) to the informative-but-reflexively-pro-regulation (James Kwak) to the always-interesting-and-not-normally-in the-company-of-the-likes-of-Frank-Pasquale (Marc Hodak). […]