March 03, 2015
Section 956(b) of the Dodd-Frank Act calls for elimination of compensation schemes that encourage “inappropriate risks by covered financial institutions.” What follows is a discussion of precisely how financial sector compensation could be reformed so as to achieve a more stable financial sector.
One of the most important areas for Wall Street reform is banker compensation. While many commentators have been outraged at the amount of money made by traders and executives in the financial sector, it’s clear that compensation packages are more than just a number: the way that banks and other institutions pay their traders and executives is important too. Reforming banker compensation would be one of the best ways to prevent financial crises; indeed, in Crisis Economics, Nouriel Roubini and Stephen Mihm (2010) write: “[Compensation] is where the problem originates, and it’s where the solution should be focused” (pg. 187).
Many employees in the financial sector receive both bonuses and company shares as part of their compensation packages. Bonuses are typically based on short-term returns, and while employees are usually forced to hold their stock for a fixed period of time before they can sell it, that time period is usually just a few years (Dash 2009; Roubini and Mihm 2010). One of the first steps could be extending these time periods; this would force employees to focus on the long-run health of the company rather than on making investments that may eventually go bad in order to realize quick, outsized initial profits.
A second step that could accompany lengthening the holding period for stock awards would be to allow stock options to be exercised not only above the initial market price but also below it. To explain: high-level management—CEOs, in particular—are often given shares in their company, and are told that they can cash in the shares only if the share price rises above its current price (Norris 2007; Krugman 2007). The thinking is presumably that managers who mismanage the company and cause the share price to fall shouldn’t be compensated when they make mistakes. However, by not allowing banking executives and traders to exercise their stock options if the share price falls, another problem has been created: “An option holder will get rich if the stock soars, but he is no worse off if it falls a lot rather than a little. So a project with a huge possible profit may seem attractive even if a big loss is also possible, or even probable” (Norris 2007). Not surprisingly, companies with CEO compensation geared towards stock options are more likely to take huge risks, more likely to experience more extreme performance outcomes, and more likely to see big losses than big gains (Norris 2007). By contrast, companies whose CEOs can sell their shares below the initial market price tend to experience steady and above-average performance (Norris 2007). If the financial sector mimicked this model of compensation, perhaps it would see fewer big losses and would experience less volatility.
A third step would be to invoke public “clawback” provisions in the event that a financial institution had to be bailed out or nationalized (Dash 2009; Ritholtz 2011). Under current practices, if a bank CEO manages his company in such a way that the company generates short-term profits but long-term losses, the CEO can simply retire before the long-term losses are realized; hence the famous Wall Street phrase, “I’ll Be Gone, You’ll Be Gone,” invoked when CEOs were asked how they planned to deal with long-term problems (Ritholtz 2011). However, if CEOs knew that they would lose much of their past compensation if their company became insolvent, they might manage their companies with long-term interests more front and center.
Up until now, all of the suggestions for reform of executive compensation have been compatible with one another. Bonus payments and stock options—the latter of which could see its value either increase or decrease—could be cashed out only after long periods of time, and clawbacks could be instituted for banks that became insolvent.
A different solution would involve changing the very nature of financial sector compensation: traders and bankers could be compensated with the securities that they create (Roubini and Mihm 2010 pg. 188). For example, rather than being granted pure cash bonuses, traders could receive slices of the CDOs or other securities they design (Roubini and Mihm 2010 pg. 188). If a banker created securities that yielded losses, he or she would lose money; if the securities were profitable, he or she would make money. While this would negate the need for public clawback provisions, rules about the length of time for which these securities would have to be held would still be necessary.
Another drastic reform would be to disallow investment banks and other shadow banking institutions from being publicly traded (Ritholtz 2011). As Barry Ritholtz (2011) has noted, the financial sector took far fewer risks when CEOs were lending out their own money:
“Before these firms went public in the 1970s and 1980s, bank management had full liability for their firm’s losses. During the era of Wall Street partnerships, if employees were so reckless as to lose billions of dollars, the partners were on the hook for the full amount. This meant that after the firm was liquidated to pay its debts, the partners’ personal assets were next on the auction block: Houses, cars, boats, even watches were sold to satisfy the debt.
“Not surprisingly, partnership liability worked wonders in focusing attention on taking appropriate risks.”
Under a partnership liability scheme, bank CEOs may well have stopped the risky, reckless practices that were seen in the run-up to the 2008 crisis.
Executive compensation can therefore be reformed in any number of ways. One option is to mandate long-term holding periods for bonus payments and realization of stock options (which can fall below initial market value), while also creating public clawback provisions for bailed-out or nationalized institutions; a second option is to pay bankers with the securities they create; and a third option would be to re-create the same partnership liabilities that existed before investment banks went public in the late ’70s and early ’80s. Notably, these are not mutually exclusive solutions. For example, partnership liability could be employed for executives, but traders could receive compensation based on the securities they create. But no matter what happens, it’s clear that any of these three solutions would help ensure proper risk-taking by financial sector actors.
Sources:
Dash, Eric. “What’s Really Wrong With Wall Street Pay.” Web log post. Economix: Explaining the Science of Everyday Life. NYTimes.com, 18 Sept. 2009. Web. <http://economix.blogs.nytimes.com/2009/09/18/whats-really-wrong-with-wall-street-pay/?_r=0>.
Krugman, Paul. “Their Own Private S&Ls.” Web log post. The Conscience of a Liberal. NYTimes.com, 14 Oct. 2007. Web. <http://krugman.blogs.nytimes.com/2007/10/14/their-own-private-sls/?_r=2>.
Norris, Floyd. “Maybe It’s Time to Restructure Executive Stock Options.” New York Times n.d., Business sec.: n. pag. NYTimes.com. 12 Oct. 2007. Web. <http://www.nytimes.com/2007/10/12/business/12norris.html>.
Ritzholtz, Barry. “Putting an End to Wall Street’s ‘I’ll Be Gone, You’ll Be Gone’ Bonuses.” Washington Post 12 March 2011, Business sec.: n. pag. 12 Mar. 2011. Web. <http://articles.washingtonpost.com/2011-03-12/business/35208181_1_limit-bonuses-traders-and-managers-derivative-traders>.
Roubini, Nouriel, and Stephen Mihm. Crisis Economics: A Crash Course in the Future of Finance. New York, NY: Penguin, 2010. Print.
