Wall Street Pay: Where’s the Reform?

Today’s report on Wall Street remuneration practices from Kenneth Feinberg, the Treasury Department’s “special master” for executive pay, comes about a football jersey
year too late. After being appointed in February, 2009, Feinberg took eighteen months to discover what we all already know: Wall Street is awash in egregious self-enrichment.

The headline in today’s report, which was trailed in the Times this morning, is that in late 2008 and early 2009, at the same time they were receiving hundreds of billions of dollars in taxpayer bailouts, seventeen of the big banks paid out about $2 billion in bonuses and other payments. In a press conference today, Feinberg said these payments were “ill-advised” and “against the public interest,” but admitted he had “no authority whatsoever” to recoup the money.

The bigger story is that virtually nothing has been done to change the pay practices that Feinberg belatedly highlights. Despite widespread anger on the part of the public, and a rare consensus among economists that faulty compensation structures were partly responsible for the financial crisis, the U.S. political system has failed to rise to the challenge. The financial-reform bill that President Obama signed earlier this week contains a measure that would allow stockholders to vote on the compensation packages of senior executives. But this so-called “say on pay” will have little if any impact on how Wall Street firms pay their traders, which is at the heart of the issue.

As I pointed out in my book “How Markets Fail: The Logic of soccer jerseys
Economic Calamities,” the problem is not only one of greed—although that certainly plays a role—but of faulty incentive structures. Even today, most Wall Street firms pay their senior employees a not-too-outlandish salary (several hundred thousand dollars), with the bulk of their compensation coming in the form of bonuses that are largely paid in cash or stock options. Such a system is meant to align the interests of employees with stockholders. In fact, it can easily have the opposite effect, giving traders and their managers a big incentive to generate short-term gains while ignoring longer-term risks.

Take a trader at JPMorgan Chase who is considering making a long-term investment that has a .99 probability of generating a $1 million profit this year, and a .01 chance of generating a $250 million loss. From the perspective of nba jerseys
the firm, this is a bad bet to make: its expected value is negative $1.51 million. But from the trader’s perspective, things are different. Ninety-nine times out of hundred, the trade will work out well, and the trader’s year-end bonus will be boosted. Looking at things from a five-year perspective, the chances of something disastrous happening jump to one in twenty, but even then this is hardly likely to discourage the trader from putting on the trade. After all, if things go wrong in year four, say, he will have banked three years of bonuses, and the firm won’t have any means of getting back this money. By then, the trader might not even be at the same firm.

This is just one trivial example. But when practically everybody on Wall Street is facing the same incentive structure, the result is that the system has a tendency to take on too much risk. As we’ve learned in recent years, this excessive risk-taking poses a threat not just to bank stockholders but to taxpayers, too, and it is that threat which justifies government action in the form of forcing financial firms to change how they pay their employees.

Relying on the market to deal with this problem simply won’t work. Imagine if one firm, Goldman, perhaps, announced that going forward it was going to place eighty per cent of all its employee bonuses in deferred accounts, which wouldn’t be released for five years, and which wouldn’t be released at all if the trades that generated them turned sour. From the perspective of the firm’s stockholders and society at large, such a “clawback” compensation system would be a great improvement. But within months the firm that announced its implementation would find many of its star traders defecting to other firms that still paid bonuses in cash. The reform movement would never get off the ground, which is exactly what we’ve seen in the last year. Twelve months ago, Lloyd Blankfein, of Goldman, and John Mack, of Morgan Stanley, both made noises endorsing the clawback concept schemes. But given the competitive pressures they face, neither firm has been able to proceed very far with them.

From a game theoretical perspective, this is a straightforward coördination problem, and the solution is equally straightforward. Some outside agency, in this case the government, has to step in and force the players to coördinate on the mutually advantageous solution. The rational pursuit of self-interest isn’t enough. Since the Administration and the Congress have failed to take on board this lesson, it is now up to the Fed, which, under the Dodd-Frank bill, has primary responsibility fo soccer uniforms
r monitoring and reducing systemic risk. Last September, the Wall Street Journal reported that the Fed was preparing a tough set of pay guidelines for big financial firms to follow. Ten months later, we are still waiting for them to be announced and implemented.