Posted by Kenneth Anderson:
Bankers' Bonuses:
http://volokh.com/archives/archive_2009_07_26-2009_08_01.shtml#1249066231
Is the problem that they are too high? The [1]Washington Post reports
today on anger in Congress and elsewhere at the size of bankers'
bonuses. NY AG Andrew Cuomo's office released a report yesterday with
the unsubtle title, [2]"No Rhyme or Reason: The 'Heads I Win, Tails
You Lose' Bank Bonus Culture.". According the Post's account:
Cuomo's investigation into pay practices at Wall Street's largest
firms found that nearly 4,800 executives and other employees were
each awarded at least $1 million. Of those, more than 900 worked
for Bank of America and Citigroup, which have been among the
largest recipients of government bailout funds.
This latest report about Wall Street bonuses turned up the heat on
lawmakers and regulators, who have been weighing how to rein in
compensation practices that banking executives themselves admit
contributed to the worst financial crisis in decades. The House is
set to vote Friday on legislation that would give regulators
authority to prohibit pay practices that they deem inappropriate
and grant shareholders the right to cast non-binding votes on
executive compensation.
Rep. Edolphus Townes, chair of the House Oversight and Government
Reform Committee, announced hearings, and added, summing up pretty
well the sense of outrage:
"A few months ago, they were facing bankruptcy. Then, after being
bailed out, they're giving huge bonuses," Towns said. "I think the
American people need some answers. With the economy being the way
it is, and people suffering . . . how do you still do that?"
Are we headed to a system of government setting compensation limits
for executives in banking and elsewhere? He who pays the piper, etc.
If government and the taxpayer are going to be stuck holding the bill
moral hazard when things go bad, then it is hard not think something
like this. The ultimate insurers ought to be able to lower their costs
if the taxpayers are essentially employing people. But the fundamental
problems aren't the cost of bankers - the fundamental issues are
aligning incentives, how efficiently bankers allocate capital and
credit (including limiting it and leverage) and their incentives to
get it right, and the efficient levels of risk. The article goes on to
quote some very smart people on the underlying incentives problems - I
particularly recommend Harvard Law professor Lucian Bebchuk's
[3]papers on the compensation problems. Bebchuk is quoted in the
article:
"The details of design in many cases still fall short of what is
necessary," said Lucian Bebchuk, a Harvard law professor who has
met with Obama administration officials to discuss pay principles.
"There is substantial distance we need to go before we have
effective tying of pay with long-term results."
My general impression of the economics literature pre-crisis is that
it tended to simplify and abstract away from the actual workings of
institutions and agents on the inside. I think that has also been true
of corporate finance law literature, as we have tended to assume that
efficiency in markets takes care of itself, and forces efficiency
within institutions. We are about to see a flood of literature taking
account of "secondary" actors within financial institutions - and much
of it, like Professor Bebchuk's work, is likely to come from corporate
finance legal scholars, who often have a better idea of how
institutions work. For example, see [4]this piece by Steven Schwarcz,
downloadable at SSRN, on secondary tiers of managers and their
incentives within financial institutions. The read [5]this Wired piece
by Felix Salmon, with this note on secondary management failures:
Bankers should have noted that very small changes in their
underlying assumptions could result in very large changes in the
correlation number. They also should have noticed that the results
they were seeing were much less volatile than they should have
been�which implied that the risk was being moved elsewhere. Where
had the risk gone?
They didn't know, or didn't ask. One reason was that the outputs
came from "black box" computer models and were hard to subject to a
commonsense smell test. Another was that the quants, who should
have been more aware of the copula's weaknesses, weren't the ones
making the big asset-allocation decisions. Their managers, who made
the actual calls, lacked the math skills to understand what the
models were doing or how they worked. They could, however,
understand something as simple as a single correlation number. That
was the problem.
(In a later post, I want to take up something at a more abstract
level, something for which Lucian Bebchuk's papers have been
illuminating for me, along with the writings of [6]Duke Law School's
Deborah DeMott - the need to re-enshrine "agency" as a body of finance
law, and the need for economists to find ways to absorb it into their
assumptions and their models, and not merely as a weird, special case
of contract.)
References
1.
http://www.washingtonpost.com/wp-dyn/content/article/2009/07/30/AR2009073001581.html
2. http://www.oag.state.ny.us/media_center/2009/july/july30a_09.html
3. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1410072
4. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1322536
5. http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all
6. http://www.law.duke.edu/fac/demott/
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