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.