Beating Bonuses into Risk Controls

by Chidem Kurdas

Deferred vesting of stock options is not a new idea—it gained currency amid the corporate scandals that emerged in the aftermath of the late 1990s stock bubble. It appears to be making more inroads at present, in the aftermath of the twin credit and property bubbles.

This growing practice is not confined to Wall Street, but financial firms are the forefront.  Given that bonuses, and hence stock awards, tend to be by far the largest portion of managers’ pay in the financial industry, the restrictions have the potential for curbing bad behavior in the future.

This may be the one useful result of public anger over outsize compensation and the political grandstanding it has occasioned. It could go some way to reduce the perverse incentive created by the government safety net and cheap federal loans, which are in effect an invitation to put the money to use in lucrative but hazardous ways.

Last month Goldman Sachs announced that its 30 top executives will receive as their bonus only company stock that will not vest for five years.  Moreover, the company can take the stock back “in cases where the employee engaged in materially improper risk analysis or failed sufficiently to raise concerns about risks.”

Other large banks are reshaping compensation along similar lines. Morgan Stanley instituted claw-backs that allow the firm to reclaim compensation for up to three years if there are losses on certain trading positions, investments or holdings.  JP Morgan will repossess the stock bonus of any employee found to have taken excessive risk or not complained about bad risk-taking.

Even hedge funds are under some pressure to delay the vesting of their fee compensation and give back part of the fee if they subsequently lose investors’ money.  Delayed vesting tied to long-term results should discourage excessive risk taking.

There are questions as to who in an organization should be subject to these rules and how to align the individual’s responsibility for long-term consequences with financial penalties—only top executives or all employees who receive bonuses, the person who made the reckless trade or his supervisor as well?  And there are doubts as to how rigorously the rules will be enforced. But the changes are steps in the right direction. Slow as the process may be, better incentives are evolving.

The Federal Reserve apparently approves claw-backs as a way to link pay with risk-taking. Now, shouldn’t similar rules apply also to public sector compensation? The Fed’s own bureaucracy, having generously provided the liquidity for asset bubbles over the years, might need to have its own pay geared to avoiding booms and busts.

Or take the US Securities and Exchange Commission. It would seem to be a good idea to have monetary penalties for a bureaucracy that is capable of so monstrous a failure as letting Bernard Madoff off the hook year after year, despite repeated warnings and even news stories of fraud.

Come to think of it, there could be disincentives against running trillions of dollars in deficits. Say, part of Congressional salaries to be vested in four years, but only if federal spending comes down. That should do the trick.

9 thoughts on “Beating Bonuses into Risk Controls

  1. Excellent points, Chidem. Such compensation ideas are also percolating up in the hedge fund industry. More hedge funds are structuring fees with similar clawbacks etc.
    The difference, of course, is that financial institution compensation is set primarily (thought not exclusively) through a market process, while public sector compensation is set through a political process. At the risk of sounding cynical, it is not possible for that political process to implement the kind of compensation scheme you have suggested.

  2. It would be better to remove the three pillars governments have erected against economic busts: the lender of last resort function arrogated by central banks, government-provided deposit insurance, and lately the implicit guarantee against bank (and other industries, e.g. the auto manufacturers) failures (the “too big to fail” doctrine).
    That means replacing central banking and fiat money with free banking and privately supplied money.
    Then it won’t matter what banks do with bonus pools or how big they are.

    I assume the last couple of paragraphs above are written tongue in cheek.

  3. I dunno, Chidem. Wouldn’t they game those claw-backs? Someone must decide if you took excess risk. There is disagreement (honest or otherwise) on whether you did so. It ends up in court. You end up with a lot of case law meant to nail Jell-O to to the wall and, therefore, lots of legal uncertainty. I just see a mess.

    Maybe I’m just being sour or something, but I see a problem in the interface between discretion and legally binding rules. Property rules have evolved over time to align the property right with the exercise of discretion. The property right creates a default that that tends to liberate discretion to operate freely. But with claw-backs and all things are out of alignment. Essentially, person A gets to exercise discretion over the use of Person B’s property. Isn’t that a problem?

  4. Bill Long– I take your point. It is unlikely that the political process can provide incentives for relatively prudent behavior. However, it is useful to think of the institutional changes happening in the private sector in relation to the public sector. After all, the whole problem of “too-big-to-fail” and moral hazard turns on the interaction between the financial sector and government.

  5. Bill Stepp- Absolutely. If those changes you describe were to happen, “Then it won’t matter what banks do with bonus pools or how big they are.” I’d submit that while federal compensation incentives are unlikely, the changes you describe are even less likely!

  6. Roger- You raise fundamental issues. No question, claw-backs will result in some litigation. The issue here, though, is assigning property. The bonus is not yet person B’s property–the contract says that for x years it can revert back to the company if the company ends up losing a lot of money because of person B’s actions.

    There is the problem that maybe the money is lost because of person A, who will shift the blame to person B and withhold her bonus!

    Lot of nasty complications, to be sure. But, unfairly as it may be used, won’t an incentive effect still be there? People will know that if they, say, crank up the leverage to make money now, the consequences can come back to bite them financially over x years.

  7. Chidem,

    The incentive is there to the extent that the simple description is accurate, although the bad consequences of legal uncertainty may be worse than the current problem. The incentive will be absent to the extent that the simple description is inaccurate because of gaming the claw-backs and so on. I find it hard to predict how things will look once the dust settles. My biases, however, resist politicized compensations schemes in politicized markets.

  8. Roger- Re the narrower issue of financial industry compensation, once this practice becomes well established, there would be less uncertainty about it. Granted, that will take years.

    I’m not sure how widely you’re defining “politicized markets”. Give the wide scope of government intervention, it is hard to find a major industry that is not politicized–as Mario reminded us in his post on the Supreme Court decision about corporate political spending.

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