This week, Becker and Posner take on the Obama administration’s “Pay Czar,” with predictably critical reactions. Posner, in particular, discusses an issue near and dear to my own heart (see here, here and here) -- trading floor compensation and compliance issues. As Posner notes:
Still another distinct problem is that of compensation practices of banks and other financial intermediaries. Here the problem is not the compensation of top management, but the compensation of traders and other investment officers at the operational level. The concern is that compensating them on the basis of the profitability of the individual deals that they make motivates them to take excessive risks.
. . .
Financial firms that worry as they should about such a catastrophic risk (since the firm makes many deals, which multiplies the risk of disaster), typically try to reduce it by employing "risk managers" who review proposed deals. Because this method of limiting risk failed to avert the financial collapse of last September, there are suggestions that it be supplemented or replaced by rules limiting the cash bonuses paid to traders, instead compensating them in restricted stock of the corporation, which they cannot sell for a number of years, or authorizing the corporation to "claw back" any bonus they receive should the risk involved in one or more of their deals later materialize and reduce or eliminate the profit that the corporation made on the deals.
As I discuss in this recent paper, financial institution managers and regulators have long been aware of the moral hazard problems posed by most trading floor incentive compensation plans. Several institutions, including Salomon Brothers, have flirted with drastic revisions, but never with any lasting success. For example, after the firm’s 1994 trading scandal, Salomon overhauled its compensation system to provide investment bankers, traders, and other employees with as much as half their pay in Salomon Brothers stock at a 15% discount, which could not be sold for five years. After announcing the plan, which was quickly discontinued, Salomon lost dozens of employees, including a large number of traders.
The recent financial crisis has once again focused hot attention on the issue of trader compensation. Morgan Stanley, which in 2008 revised its compensation policy to provide traders with 65% of bonus pay in deferred compensation vesting over three years, is one of the most recent and prominent examples. But Kenneth Feinberg, the new “pay czar,” may decide that other institutions need a compensation overhaul as well.
As I emphasize, and Posner notes as well, financial institutions have a chance to externalize some of the costs of this type of risk-taking, and thus do not have the incentives to set trader compensation at the socially optimal levels that we might otherwise expect. He concludes that:
An external cost is a conventional justification for regulatory intervention--in principle. But the specific suggestions for curbing risk taking by traders are problematic. There are many influences on the value of a corporation's stock besides the outcome of a particular deal, and a claw-back possibility can greatly reduce the present value of a bonus, as well as complicating the recipient's tax and other financial planning. I conclude that it is premature to start regulating compensation practices in the banking industry; there are other ways of reducing financial risk that are less problematic.
As we emerge from the financial crisis into a new regulatory landscape, I presume that those “other ways” of reducing financial risk will receive much attention.
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