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Summers wades into bankers’ pay fracas

Ok - so we’d agreed that the Epicurean Dealmaker could have the last James Bond-themed word in this spat. But it would be remiss not to draw readers’ attention to the response of Larry Summers to Martin Wolf’s call for regulation of outsize banking pay packets.

The devastation of repeated banking crises, argued Wolf, justifies the spectre of official intervention. The current system of paying huge bonuses on the basis of short-term performance creates incentives to disguise risk taking as value creation. Pay should be better aligned to the realities of the business - made in restricted stock redeemable over a run of years.

In at least two respects, the argument is flawed, retorts Summers, writing in response to the piece on the FT’s Economists’ Forum:

First, he asserts that the change he suggests is not one that any one bank can make unilaterally. Why not? If he is serious about caring only about the structure of compensation not the level, then a bank that wants to change to a system that better aligns incentives can do this and can provide a level of compensation sufficient to compensate for the deferral element. Presumably if the whole industry is forced to make this change something similar will happen. Second, there is a distinction under recognized by Martin between compensating people based on annual profits and compensating them based on stock market performance which recognizes forward looking risks. There is a reason why trading houses and especially those with a reputation for risk taking have much lower p/e’s than other institutions. Managers compensated in stock or options have strong incentives to run their firms in ways where they are credibly around for a long time. Third, there are all kinds of technical problems–what about managers ability to hedge their stock? What about their excess incentive to sell out their institution so as to realize gains early?

The first point relates to the possibility of an exodus of top talent from the bank which unilaterally moves to reduce the cash portion of bonuses. Of course, in bad times this happens regardless, such as at UBS which has upped the portion of bonuses paid in stock (although it may allow bankers to sell their shares more quickly than previously, as soon as after one year, to help keep the peace.)

Summers concludes:

There is the meta question of whether if public humiliation and a foreshortened tenure of earning 30 million a year does not deter behavior Martin doesnt like why will deferred stock? I think these are all serious problems but it is easier to be critical than constructive. I am inclined to think that leaving stock prices out of it and causing traders’ compensation to be more subject to clawback after bad years may have merit.

Just when TED thought he might have an ally. Clawback was the subject of another contentious opinion piece two weeks ago penned by Raghuram Rajan, suggested that portions of compensation be held in escrow to be paid out (or not) over time.

Clawback though seems as problematic logistically, if not more so, than stock. Much easier to give out shares which may be worth less down the road, than to hand out goodies only to confiscate them for bad behaviour. The reason this might be appealing to some is that presumably such a mechanism might be better able to target the retribution bonus-wise on those whose investments have run adrift. Around the City, bankers are fuming that a four-man team buried somewhere in the fixed-income department has ruined their party.

But the losses formed around the four-man team were out of proportion with its size (as were their earnings in the good times), and turned out to be big enough to put a serious dent in a bank’s standing and balance sheet. Which makes it a firm-wide problem, shareholders included.

Felix Salmon previously suggested that the way to kick-start clawback would be for Goldman to be the first to move, only to be informed by his readers that it already had. Goldman apparently claws back at the group or strategy level, rather than at the individual trader level, to reserve against long-term negative outcomes even when there’s an immediate profit. And everyone wants to work there. Especially at the moment.

This entry was posted by Helen Thomas on Monday, January 21st, 2008 at 12:43 and is filed under M&A, Capital markets. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.

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Comments

  1. Jan 23   2:59 Posted by 1-2 [report]

    Mr. Wolf, no rebuttle? I’ll declare this a victory by judging:

    TED/1-2: 1
    Wolf et al: 0

  2. Jan 21   18:12 Posted by 1-2 [report]

    Hmmmm…where else could we add Clawback Provisions??

    Athletics: In any economic “tournament” there are bound to be “outsized pay” for short-term performance. Baseball, football (take your pick on which version), etc all pay base salaries and most have contractual bonus clauses. Seeing as how the dispersion of pay amongst players is IMHO equivalent to bankers’ salaries should we escrow the money of the “breakout player” who fails to perform the following year? This sounds right up Congress’ alley, doesn’t it? Set up a clawback mechanism for athletics. It doesn’t seem like they have much else to do. Miguel Tejada should probably give back post-MVP year contract; Beckham should probably be giving all his money back to the Galaxy; any Rookie of the Year should probably pray he STARTS taking steroids just to make sure he gets to keep his performance bonus.

    Furthermore, there’s fact we have to discount the opportunity cost. At what rate should that be done? As i said when i spoke about front-loading bonusesI think you would see a lot more egregious salaries after we inact such financial shekenery. Perhaps we should get rid of bonuses all together, not pay for any short-term or long-term performance and just make sure everyone shirks enough to simply keep their job.

    On another note, i’m in Aspen right now and exceptionally hungover. My apologies for grammar and spelling. Just read my post for the points.

    Seems like it’s just you and me TED.

  3. Jan 21   15:42 Posted by Martin Wolf [report]

    I find it impossible to take seriously someone who froths anonymously, though I suppose that, like most economists, I would be happy to take delayed pay in return for bankers’ levels of remuneration. The fundamental point, however, is that banks are already differentially regulated and for very good reason: they are the central institutions of the credit system, as this crisis has proved once again. And, as the central institutions of the credit system, they are uniquely protected and supported by the state.

    It is perfectly reasonable for regulators to ask whether the incentives of those who operate these institutions are aligned with the public interest that the regulators exist to protect. Of course, it is quite likely that regulators will soon be looking at how other industries (real estate brokers, for example) have performed. But that was not my concern.

    “Academic” is often used as a term of abuse. But pretty well all the fundamental ideas in modern monetary and financial economics were invented by academics. So it is a term of abuse I am delighted to accept.

  4. Jan 21   15:24 Posted by The Epicurean Dealmaker [report]

    This horse just won’t die, will it?

    I find it both instructive and amusing to read the thoughts of the great men (no women yet) on the FT Economist’s Forum. The scent of academe lies heavy upon the conversation, whereas I could find little evidence that any of those learned men have actually spent any time earning a productive living in the finance sector, which might give me more comfort that they know what the hell they are talking about.

    “Clawback,” as Mr. Rajan originally proposed and Mr. Summers seems to tentatively endorse, is both a ludicrous notion and so impractical as to rank only slightly above unicorn horn as a likely cure for the current financial ills Mr. Wolf and others so lament.

    How, pray, would you implement such a scheme? Set up a government-supervised escrow account, into which all affected traders and bankers deposit a majority of their annual pay, which is only released over time when the regulators decide it is safe or appropriate to do so? To whom among the legions of individuals within the finance sector–whose jobs and responsibilities are so multifarious as to make the US Federal tax code look like a one-page precis–would it apply? Who would decide, for example, when it is safe to release the 2007 bonus for a mortgage trader, and on what basis? How about that for a CDO structurer, or a commodities trader? An M&A advisor? A senior executive? (Minor point: how in God’s name would you propose taxing such earnings?)

    The mind boggles both at the size and complexity such a regulatory scheme would require and the self-delusion of those among its proponents who believe that Wall Street and City bankers will not innovate rings around such a system within the first six months of its establishment.

    And why should investment and commercial banks be the only entities involved in such a scheme? I can think of many economic actors who had a direct hand in the frenzied bubble behavior behind the current credit meltdown and real estate crisis who are at least as influential and culpable in the resulting mess as bankers. Let’s set up compensation clawback mechanisms for them, too, by all means. Real estate brokers, fixed income portfolio managers, German savings banks, Australian municipalities, central bankers, and–dare I say it–economic prognosticators should all join the party, by this calculation.

    Furthermore, if we agree the assets and securities being traded carry long-term risks of value diminution, why don’t we extract protection directly from the sellers of those assets? After all, the seller of a house, a mortgage portfolio, or a common stock share has absolutely no continuing exposure to the potential future reduction in value of that asset, and they typically make a lot more money off the sale than the banker who arranged the transaction. Outrageous! If we want to protect the financial economy from panics, crises, and destruction of value, why don’t we “incentivize” all sellers of financial assets not to sell any assets which have a risk of declining in value in the future? That’ll simplify things, mightily.

    This is, and remains, nonsense. There are vast swathes of our global economy where people earn a living conducting transactions in which their pay has no long-term vesting mechanism even though those very transactions have substantial long-term economic risk to their participants. Wall Street, frankly, is one place where it does, through the cleverly designed market mechanism of deferred compensation tied primarily to the stock price of the individual banker’s employer.

    Until and unless the economists of the world propose to set up a compensation scheme wherein their current compensation is deferred until we have had the opportunity to judge the correctness and efficacy of their economic forecasts and policy proposals over some multi-year time period, I will consider such proposals as these as no more than empty posturing.

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