SEC: Watch those broker incentives!

Posted by Marc Hodak on September 1, 2009 under Regulation without regulators | Read the First Comment

SEC Chairman Mary Schpiro sees Wall Street’s aggressive pursuit of top brokers, and sees red:

“Certain forms of potential compensation may carry with them enhanced risks to customers,” Schapiro wrote. “For example, if a registered representative is aware that he or she will receive enhanced compensation for hitting increased commission targets, the registered representative could be motivated to churn customer accounts, recommend unsuitable investment products or otherwise engage in activity that generates commission revenue but is not in investors’ interest.”

This sounds good…to people unfamiliar with the way the average owner balances incentives and controls.  If all we had to worry about were incentive effects, then the average restaurant owner who allowed their waitresses to keep their tips would risk their waitresses nudging their customers toward the more expensive fares like the unpriced specials.  The average law firm billing their lawyers by the hour would risk their associates padding their hours to the detriment of their clients.  The average district attorney’s office whose DA’s election chances are increased by headlines might pursue headlines at the expense of justice in the case of politically unpopular individuals.

These things all happen, of course, but that’s not the point.  The point is that it is impossible to disentangle the sensible from the perverse aspect of common incentives.  Allowing a waitress to keep her tips encourages better service.  Allowing lawyers to bill by the hour encourages them to go the extra mile to dig up the materials that will help their clients win their cases.  Requiring DAs to go up for election provides a measure of accountability to the public the DA is supposed to serve.  Similarly, giving brokers an interest in the commissions they generate can encourage them to seek out new customers and recommend suitable investment products that they are selling to a largely skeptical public.

What’s missing from Shapiro’s analysis is the fact that incentives aren’t implemented in a vacuum.  They are implemented alongside controls.  The waitress who somehow snookers her customers, even if they don’t know they’ve been snookered, is liable to be chastised by her boss if he cares about the reputation of his business.  The partners are supposed to monitor the reputation of their firm.  The governor and the press are supposed to monitor the DA.  Are there monitoring failures?  Of course.  But that’s not an indictment of the incentives, either.

Shapiro seems to conflate these items, however, by reminding the CEOs of their “significant supervisory responsibilities” over broker-dealer activities while condemning routine incentives of the kind that permeate our society, all of which, absent reasonable controls, could become perverse.

The final irony is that Mary Shapiro’s personal incentives are subject to perverse controls.  With Ms. Shapiro, we must rely on her personal sense of what she considers the right thing to do, tempered by her marketability in the private sector once her reign at the SEC is done, and tempered by the total lack of control exhibited by her easily embarrassed patrons in the Obama administration and, especially, in Congress.  It’s like a waitress or law associate being under the control of unscrupulous drama queens.

  • Craig H said,

    “Under the control of unscrupulous drama queens.”

    You must know the firm I work for.

Add A Comment