Tuesday, September 15, 2009

An Idea for Bank Pay Reform

In general government regulation hurts economic growth. However, there are circumstances where minimal controls may be necessary. Wage controls and banking/trading are particularly tricky because bankers and traders can easily evade national regulation by moving to foreign firms while still operating in domestic markets. Despite the public outrage at Wall Street, its not entirely clear if pay regulation is necessary, but if it is, here are a couple ideas on how to approach it.

First, lets clarify that the goal of any regulation should not be to punish. It doesn't matter how much bankers and traders earn relative to the general public or that they may be perceived as overpaid. Everyone loses if regulation disincentives economic growth so there is no point in capping pay if the goal is assuaging the public.

The goal of any regulation should be to add stability to the system without dampening growth. In this case the goal of pay regulation should be to more closely align the banker/trader's interests with the long term success of the firm they work for. The problem with compensation is not how much is made, but rather how its made.

The problem in a nutshell is that system rewards individuals for taking outlandish risks without much downsides. Barney Frank calls it "Heads I win, Tails you lose." For example:

Year 1: Trader nets $100M for the bank and receives a $3M bonus
Year 2: Trader looses $200M for the bank and gets fired

Net-net, the trader has lost $100M for the bank but got paid a handsome $3M over a 2 year period and while s/he was fired, finding a new job probably won't be too difficult. Heck, even if takes them 2 more years to get a job they'll still average $750K per year in compensation over the total 4 year period. Thus, it really doesn't matter how much of the bank's money a trader looses over the course of his/her career so long has s/he has a couple good ones to lock in multi-million dollar bonuses. Thus the individual is rewarded for destabilizing the system by gambling with the banks money in order to maximize their personal compensation.

An outright compensation cap would be problematic because it wouldn't reward those that go above and beyond and could lead top talent to flee to unregulated foreign banks. However, shifting compensation above and beyond a certain level from cash to stock grants on a vesting schedule would align the banker/trader with the long-term interests of the bank that s/he works for. By putting the excess bonus into a stock grant the banker/trader would be motivated to maximize the value of his/her firm's equity and by putting the grant on a vesting schedule the interests could be aligned over a number of years.

Its tough to say exactly at what level the cash bonus cap would be most effective or over how many years the vesting schedule should be. Getting it wrong could be ineffective and/or lead to talent flight. However, a $1.5M cash cap and a 3 year vesting schedule seems like good starting points for discussion purposes. While many analyst/associate level bankers make bonuses that are below the $1.5M level, the managing directors that they report to (and who ultimately decide the analyst/associate bonuses) will be effected by the compensation plan and therefore highly motivated to run their departments with the goal of maximizing the firm's stock value.

Going back to the two year scenario above, in year 1 the trader would get $1.5M in cash upfront and $1.5M worth of stock in his firm vesting over the next 3 years. In year 2 the trader is highly motivated to do what is right for the firm because if s/he is fired or leaves the firm for any reason a portion of the bonus will be lost. On the contrary, if the trader makes a positive contribution to the firm's growth, not only will they secure another great bonus in year 2, but they will also increase the value of the stock that they were granted in year 1.

Mechanically, this could mean that large portions of what the bank would have paid in bonuses will now go into buying their own stock, which could provide a nice initial pop in stock price if the bonuses are large enough relative to the firm's market cap. Although Wall Street will likely resist any wage controls, this could be a motivating factor to get on board with pay regulation.

One downside to this plan is that the stock vesting schedule would decrease financial industry labor flexibility because moving firms would always leave 2-3 years worth of grants on the table. An approach to this problem could be enabling hiring banks to offer a hiring bonus of equivalent value (or a fraction of) in their own stock on the same schedule as the unvested portion of the banker/trader's grants at the old firm. A fraction would probably be best in order to discourage taking outlandish risks and then simply moving banks before the shit-hits-the-fan.

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At September 16, 2009 11:46 AM, Blogger tbelote said...

Seems like all the banks world wide should band together to require this kind of compensation agreement. Like how with startups it is standard to make pay largely equity and to have a vesting schedule over a few years with a cliff.

But I guess even though this wouldn't be meant to punish people it would probably mean many people would get a pay cut if their pay was really tied to their performance longer term.

At September 16, 2009 12:06 PM, Anonymous Anonymous said...

Business Cliches that would make midcaps crap smallcaps.

Leverage: "We should leverage our investment in IT infrastructure across multiple business units to drive profits."
Reach out: "Jim decided to reach out to this underutilized demographic."
It is what it is: "The server is down, and clients are irate. It is what it is."
Viral: "Our training video has gone viral."
Game changer: "The switch from LAN to WiFi was a game changer for our productivity."
Disconnect: "There is a disconnect between our customers' wants and their page views."
Value-add: "Where's the value-add in this increase in spending?"
Circle back: "I have to go, but I will circle back with the client later."
Interface: "My job requires me to interface with all levels of the firm."
Cutting edge: "Our cutting-edge technology gives us a competitive advantage."

At September 16, 2009 12:56 PM, Blogger Andrew Fife said...

the key is to create some kind of regulation that the major players are comfortable with, otherwise, there will always be free riders. Actually, the idea above might increase compensation. When the banks are doing well the value of previous bonuses would grow as the stock price rises and if interests were properly aligned bad years at the banks may be fewer and farther between. Furthermore, increasing stability may enable changes such as lowering reserve requirements that would foster overall economic growth.


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