On Compensation in Finance
This post is part of a series of essays on things unrelated to software development. You can find all the essays here.
The compensation structures on Wall Street have long been criticized as excessive, lavish and unnecessary. Banks have consistently justified such salaries, noting the executives being compensated brought in big earnings for the bank. When the bank balance sheets were positive, there was little incentive to attempt to correct the salaries, however with most banks now in dire straits, many have begun to take a more firm tone with banks.
This concern was underlined this week by Obama’s new government enforced incentive cap of $500k per year for top executives in banks receiving federal aid. While Obama has found a significant problem in banks, their compensation structure, his cap is not only horribly low, but may also have a significantly negative effect on banks. Without that ability to recruit top talent into executive positions, banks will have more trouble hiring than the offices of Mr. Madoff.
Free markets tend to assume that people will do what they consider in their best interest. Consider a classic example of a big, blue lake, full of fish with multiple fishermen. If the lake is a public entity, it is in the interest of each fisherman to collect as many fish as possible, without regard for environmental impacts or long-term sustainability. If they do not, the other fishermen will fish the entire bounty from the lake, draining it of their resource, and they’ll be left with nothing. If each fisherman owns their own portion of the lake, however, they will want to sustain their portion of the lake for future years, to ensure long-term prosperity.
The banks have begun to look much like the overfished lakes of Wall Street. With huge annual bounties, and little incentive to maintain the overall value of the organization, traders, bankers and executives alike have taken large risky bets at expense of the the organization, in effect hollowing out their balance sheets. Large bonuses rewarded short-term harvests, and threatened long-term prosperity. Even with some compensation supplied in stock options, the incentive to make a few large cash bonuses and move on was so great, that it simply eclipsed the interest in ensuring a banks long-term viability.
Compensation structures should provide incentive for employees to ensure long run profitability over short-term profits. The most obvious way to accomplish this is to lower annual cash bonuses and increase the use of instruments that mature over time, such as stock options. Employees who receive bonus compensation based on the performance of the company in five years are more likely to ensure that the organization maintains long term profitability, and is less likely to take risky bets that undermine the banks sustainability and performance.
Obama is right to point out the broken compensation structures on Wall Street, but the amount of the compensation on Wall Street is not the cause of current economic woes. It is the form of compensation and how that from makes people act. Obama should not be looking at limiting overall executive pay, but rather rewarding success in solidifying a firm over the long run. If a salary cap is necessary to push a bill through congress in the short term, a bonus structure should be provided for any executive who has been instrumental in restoring confidence and a positive cash flow to a bank. Change in the way banks provide incentive to their employees is necessary, but populist politics should not get in the way of proper reform.