Fixing bankers’ pay

By Felix Salmon
June 16, 2010
Squam Lake Report this afternoon, where Harvard's Jeremy Stein has just given a very compelling presentation on the subject of executive compensation at banks. His bright idea is that you don't regulate the level of pay at banks, and that you certainly don't try to convert pay into stock, for reasons similar to those glossed by Justin Fox at HBR:

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I’m at a conference on the Squam Lake Report this afternoon, where Harvard’s Jeremy Stein has just given a very compelling presentation on the subject of executive compensation at banks. His bright idea is that you don’t regulate the level of pay at banks, and that you certainly don’t try to convert pay into stock, for reasons similar to those glossed by Justin Fox at HBR:

Equity in a highly leveraged firm (banks and investment banks have debt-to-equity ratios that start at 10-to-1 and go much higher) is equivalent to a call option. That is, if the firm goes bust the equity holders only lose a little but if it does well they can reap huge rewards. So shareholders have every incentive to push executives at highly leveraged firms to take big risks (and executives with big equity stakes have every incentive to take big risks).

This conforms with what we saw at Bear Stearns and Lehman Brothers, where the managers had large equity stakes.

So what to do? “It’s important to get incentive alignment,” said Stein, between managers and taxpayers. And one way of doing that is to force a large part of executive compensation to be paid in cash — and then to hold back that cash for several years, to be surrendered in the event that the bank fails or receives exceptional government support.

Stein writes:

Familiar forms of deferred compensation, such as stock awards and options, do little to reduce the conflict between systemically important financial institutions and society. Managers who receive stock become more aligned with stockholders, but this does not align them with taxpayers. Managers and stockholders both capture the upside when things go well, and transfer at least some of the losses to taxpayers when things go badly. Stock options give managers even more incentive to take risk. Thus, compensation that is deferred to satisfy this regulatory obligation should be for a fixed monetary amount. For example, firms might be required to withhold 20% of the estimated dollar value of each executive’s annual compensation, including cash, stock, and option grants, for five years. At the end of this period, employees would receive the fixed dollar amount of their deferred compensation if the firm has not declared bankruptcy or received extraordinary government support.

The ECB’s Lorenzo Bini Smaghi, at the conference, was broadly sympathetic to this idea, but feared — as I do — that it might not be particularly effective: after all, 80% of bank-executive compensation is already more than enough for anybody, so they might not care enough about the other 20%. And five years might be too short, given the length of the business cycle. Still, it’s a start.

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Comments
10 comments so far

Indeed, I would be more inclined to go 20/80 in the other direction. Or simply to apply the rule to 100% of bonus compensation.

Posted by dWj | Report as abusive

so rather than giving them call options, give them equity minus a slightly out of the money call. ie cap their upside, which caps their incentive to take risk.

Posted by q_is_too_short | Report as abusive

me again. the other piece of this is that stock options given to employees are equity and count as bank capital, and if you gave the employees cash (even if deferred) it would not.

Posted by q_is_too_short | Report as abusive

So we want to give them incentives that align them with the taxpayer, but their fiduciary duty is to the shareholder? I think it’s going to take more than this to solve the limited liability problem.

Posted by absinthe | Report as abusive

The concepts of peging saleries to the ‘Tax Payer,’ appear to be a little skewed.
The Bank’s primary duty is to its depositors and then to its share holders and employees.
Their problem at present is the banks have been running a book and lost.
If a bookmaker or casino goes bust it is their problem and they do not come to the tax payer and obtain a free loan to allow them to carry on running the book making business.
If they want to bet the firm on a particular outcome they are quite entitled too, however they are not entitled to say we must have a hand out we are too big to fail.

Posted by The1eyedman | Report as abusive

Proper alignment with the taxpayer would entail paying bankers an amount equal to the average taxpaying account-holder salary, investing any bonus funds proportionately across the relevant 401k spectrum, deferred forever.

Think they might go for it?

Posted by HBC | Report as abusive

“So what to do? “It’s important to get incentive alignment,” said Stein, between managers and taxpayers. And one way of doing that is to force a large part of executive compensation to be paid in cash — and then to hold back that cash for several years, to be surrendered in the event that the bank fails or receives exceptional government support.”

What? Why not just pay the majority of compensation in equity (stock options) and ‘hold it back’ for several years? I don’t see how this would create incentive for risk taking?

Posted by inboulder | Report as abusive

Obama needs to match the UK 50% tax rate on banker payouts. We just launched a facebook competitor at story+burn dotcom

Posted by Storyburn_has | Report as abusive

Dear Felix,

I also think that deferred cash compensation is preferable, something like 1/3rd per year for three years.

But what’s perhaps more important is the calculation of bonuses, rather than the form they take. It’s completely insane, particularly in a financial institution, to reward someone based on revenue, without accounting for the risk assumed in generating that revenue — effectively you end up subsidizing thousands of roulette wheels spinning in parallel. It would seem to make a whole lot more sense to calculate one’s bonus based on profits above and beyond the cost of capital. That, combined with delayed cash payments, could help a great deal in nudging traders and / or bankers towards internalizing the cost of risk in their relentless pursuit of revenue (it also might help shrink the banks, incidentally).

Basically I’m talking about EVA: http://en.wikipedia.org/wiki/Economic_va lue_added.

Thanks,
ISOK

Posted by ISOK | Report as abusive

Oh for the love of God, Jimmy Cayne lost a paper wealth of nearly a billion USD, Fuld lost hundreds of millions. If that ain’t going to motivate you what is?

And they also stuck their money in the company equity for years, sometimes decades and clearly equity meets the not paying out if “the firm has not declared bankruptcy or received extraordinary government support”. Or is he saying that CEOs should be forced to be unsecured lenders to the bank for say five years in return for what? There going to be a cap on the interest they will receive on this “investment”? Why five years? Why not 10? Or 100?

Posted by Danny_Black | Report as abusive
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