Financial Sector Compensation

Paul Krugman remarks on the need for reform in compensation schemes in the financial sector:

What’s wrong with financial-industry compensation? In a nutshell, bank executives are lavishly rewarded if they deliver big short-term profits — but aren’t correspondingly punished if they later suffer even bigger losses. This encourages excessive risk-taking: some of the men most responsible for the current crisis walked away immensely rich from the bonuses they earned in the good years, even though the high-risk strategies that led to those bonuses eventually decimated their companies, taking down a large part of the financial system in the process.

The Federal Reserve, now awakened from its Greenspan-era slumber, understands this problem — and proposes doing something about it. According to recent reports, the Fed’s board is considering imposing new rules on financial-firm compensation, requiring that banks “claw back” bonuses in the face of losses and link pay to long-term rather than short-term performance. The Fed argues that it has the authority to do this as part of its general mandate to oversee banks’ soundness.

Given the assumption that once a bank has reached a certain size it won’t be allowed to fail some sort of restriction on compensation is a necessity. I’d prefer that banks be prevented from reaching a size at which their failure would have systemic consequences but that’s a proposal that has no legs at all—neither Democrats nor Republicans seem to have any sympathy for it.

There’s a much simpler reform that would do the trick, too: limit total compensation to current year revenues less accounts receivable. I’ve got to admit I’m a radical on this subject. If I were king, I’d limit the maximum individual compensation in any company, financial sector or automaker, that has been bailed out by the federal government, to that of a GS-14.

4 comments… add one
  • PD Shaw Link

    Isn’t that the wrap on Congress — they are rewarded for short-term gains at the expense of long-term finances?

  • Absolutely. That’s why I believe in a host of reforms that would tend to reduce the rewards of being a Congressman. For example, I believe that no elected official should receive a pension from the government for his tenure in office. Period.

    I also believe that when Congress is in session that Congress should be housed in barracks and that there should be bed-checks, that there should be a complete ban on earnings other than their wages as a Congressman or a blind trust, that only constituents should be allowed to lobby Congressmen, and Congressmen should not have personal staffs other than a single secretary. And that for the purposes of qualification for office you’re a resident of whereever you spend 184 nights a year.

  • Drew Link

    Krugman is a guy I rarely agree with, but he puts his finger on a real problem: the mismatch between short and long term compensation performance. This should be the subject for Board compensation committees, but since we decided that the Feds would bail out private enterprises, a practice I wholly disagree with, we have created a problem.

    The revenues less AR suggestion misses the mark. Fees are usually paid at transaction close; there is no AR. This strategy works wonderfully for industrial companies, where salesmen’s bonuses or commissions are routinely based upon gross margin (as opposed to sales) and final AR collection. But financial transactions have finite AR, and the structural problems took years to develop. Not workable.

    The GS 14 proposition has populist appeal, but would be suicidal and not in the interests of the people who bailed out the institution. Better: no bail out.

  • steve Link

    This was a problem before the bail outs. It is part of what lead to the need for bailouts. What we need is some way for execs to suffer on the negative side as much as they benefit on the positive side. If there company goes bankrupt, they go bankrupt. This also needs to reach past the time of resignation. Maybe we should do away with LLCs?


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