compensation packages and financial crashes

Journalist John Cassidy, in a lengthy extract from his new book, How Markets Fail: The Logic of Economic Calamities, explains why Wall Street compensation packages are dangerous for the economy.

When the markets are rising and deals are getting done, traders, investment bankers and their bosses are paid magnificently; when things go wrong, the shareholders of the firms and, in extreme circumstances the taxpayers, suffer the bulk of the losses.

The market failure begins on the trading floor …. Some trading desks give their employees up to half of the profits they generate above a certain target. However, the trader’s downside is capped. If his trades generate large losses, he might lose his job, but he doesn’t have to write the firm a cheque to cover the cost of his mistakes. If his trades turn out badly, the firm has no recourse to his personal assets, or even the bonuses he earned in previous years. ….

[As for CEOs, remunerating them with stock options] amounts to giving them a heavily levered and one-sided bet on the value of the firm’s assets. If the bank’s investments do well, the stockholders, including the CEO, get to pocket virtually all the gains. But if the firm suffers a catastrophic loss, the equity holders quickly get wiped out, leaving the bondholders and other creditors to shoulder the bulk of the burden.

John Cassidy, “What was really behind last year’s market crash?”, The Guardian, 25 November 2009.

What is the solution? Reform from within, argues Cassidy, is bound to fail. “For although the financial sector as a whole has an interest in controlling rampant short-termism and irresponsible risk-taking, individual firms have an incentive to hire away star traders from any rivals that have introduced pay limits.” Only government can enforce compliance.

One question unanswered, at least in this extract, is why don’t shareholders – the owners of financial firms – enforce compliance by shunning firms which give outrageous pay packages to their traders and CEOs ?

One Response to “compensation packages and financial crashes”

  1. Michael Littlewood says:

    Aside from the points you note in your comments, there is a wider puzzle that builds on your last comment. The reason financial services firms, including the traders but not just them, can pay large bonuses is, at least until recently, because they made large amounts of money. So their shareholders (in some cases many the same people as the employees) could share these with the successful traders while still retaining a large enough amount to keep themselves happy.

    My question – how come the ‘markets’ allow the firms themselves to make such large amounts of money? Or is it that the ‘markets’ didn’t understand that such large amounts were being made? That seems unlikely given that the scale of the employees’ remuneration is/was widely known and anyone could have made the connection.

    I would have expected that if so many firms were making so much, the margins would have fallen and perhaps that happened but the owners were too slow to react in reducing the employees’ bonuses (or both colluded in some way to compensate those reducing margins with more and more risky deals).

    Regardless, I do not understand why people on both sides of the millions of financial trades were seemingly willing to leave so much on the table. I don’t, in this respect, blame the financial firms for hoovering it up.

    On a related issue, I have never been a fan of share schemes as a remuneration tool. I have seen no evidence of the ‘employees behaving like owners’ syndrome that is allegedly behind the remuneration advisers’ recommendations to install these complex, impenetrable pay systems. The owners and employees tend not to understand them but will happily, in the latter case, take the proceeds. If a senior employee isn’t prepared to behave in the owners’ best interests in carrying out his/her responsibilities, there shouldn’t be a salary, never mind shares, actual or notional. If employees want to buy shares, let them get them the way the public does.

    Just as employers are starting to get rid of actuaries from their deferred compensation arrangements (defined benefit pension schemes), so too should they start getting rid of remuneration ‘consultants’. Making all income taxable in the year of accrual would start to clear the brushwood.