Exorbitant compensation threatens the stability of the banking system
Few people caught in the throes of last year’s financial crisis would have predicted that only one year after the fall of Lehman Brother, top Wall Street firms would be raking in record-breaking profits—and, more pointedly, doling out record-breaking bonuses. Yet October’s earning reports confirm this to be the case. In the third quarter alone, Goldman Sachs, at the top of the Wall Street heap, made more than $3 billion in profits and will set aside $5.35 billion, almost a full half of its revenue, for end-of-year executive compensation. The public relations challenge is clear: while unemployment reaches double digits due to a recession caused by the financial sector, Goldman Sachs will reward itself with an expected $20 billion in bonuses.
Goldman’s stellar earning reports are good news for the economy, of course, because a healthy banking system is vital for economic growth. But the bonuses constitute a reminder of how little has changed in an area central to the financial crisis: the nature of banker’s compensation. The financial sector did not crash because bankers were being paid too much money, but instead because they were paid for doing the wrong things. That Goldman’s bonuses are so lavish, only a year after the unprecedented failure of the financial sector, indicates that the incentives behind Wall Street pay are still not properly aligned. Aligning them will take nothing less than a large-scale shift in the culture of compensation and integrity on Wall Street.
Bonus Questions: How? And Why?
There are two important arguments to be made in defense of Goldman’s bonuses. First, the bonuses simply reflect Goldman’s superior performance in the market, which should be applauded rather than maligned. While it is true that Goldman is good at what it does, it is also true that the company’s earnings were largely the result of the actions of the U.S. government. At each stage in the rescue, policymakers gave Goldman key support: from the $10 billion it received in TARP money, to the government’s allowing Lehman Brothers to collapse, thus giving Goldman access to huge new shares of the fixed-income market, to the government’s singular guarantee that Goldman would not be allowed to fail. In all these ways, American taxpayers underwrote Goldman’s profits.
The second argument to be made in defense of Goldman is that bonuses reflect the social function that banks perform. According to this line of reasoning, the bailout of the financial system was an essential measure to keep the credit markets functioning—to keep banks like Goldman providing loans to worthy recipients. Yet the vast majority of Goldman’s profits do not come from the lending sector. In fact, most of Goldman’s profits come from its “proprietary trading” units, which act as speculators, buying stocks and bonds and selling them back as prices vary. Unlike lending, speculation benefits only the successful speculator, thus providing almost no social value.
Short-Term Profit, Long-Term Risk
Every dollar that goes into Goldman bonuses is a dollar not going to their shareholders, the credit market, or recapitalization in anticipation of another crisis. Yet Goldman can proceed in paying out nearly 50 percent of its revenue in compensation because, unlike other industries, it has a government guarantee against its bankruptcy. For these reasons, Goldman is a case study for understanding Wall Street’s compensation problems. Not just fairness is at issue, what is at stake is instead the long-term health of the financial sector as a whole. Bonuses reward immediate gains and risk-taking, and ignore long-term losses, instability, and social costs. By attaching pay to short-term gain regardless of long-term loss, compensation packages jeopardize the growth and stability of the financial sector, and threaten to induce behavior that brought the system down last fall.
Punishing Poor Performance
In October, the Obama administration’s “pay czar,” Kenneth Feinberg, announced an aggressive plan to attack the excesses of executive compensation. For the seven firms that received exceptional support from taxpayers, the administration will slash the total compensation of the 25 highest-earning executives by nearly 50 percent. Accompanying this plan, the Federal Reserve’s guidelines for future regulatory efforts call for “balanced risk” in pay, whereby, between two traders making the same amount of money, the trader who took less risk will be paid higher. The guidelines also stipulate deferred payment of bonuses and a “claw back” clause, so that if investments later turn sour, some compensation would be returned.
While these efforts are commendable, government intervention cannot resolve the problem absent a major shift in Wall Street’s attitude towards pay. After all, the current compensation regime itself began as a flawed attempt at government intervention. As UCLA professor Lynn Stout told the HPR, problems with run-away compensation began with a 1992 law that mandated that executives attach the majority of their compensation to “objective” ex ante performance measures, like stock options or revenue streams. The goal was to make pay more rational, yet the law had the opposite effect. “In the old days,” Stout says, “an executive’s performance was determined after the fact, just as everyone else’s salary is determined: at the end of the year, the corporate board would review the executive’s performance and make a judgment to either maintain his salary, give him a bonus, or fire him.” Now, ex ante pay structures create massive incentives for executives to game the system by focusing on whichever single statistic most determines their compensation.
Thus the Feinberg plan, Stout argues, may be most significant as a return to the old notion of compensation as a reflection of one’s performance broadly understood, whereby long term stability and social value are taken into account in subjective, yearly reviews. The plan can send a simple signal that poor performance will be punished, and that compensation should be grounded in a sense of fair pay for good performance. In terms of its quantitative impact on executive pay, “Feinberg’s plan is less important than headlines would have you believe,” Ben Heineman, Senior Fellow at the Harvard Kennedy School and former Senior Vice President at GE, told the HPR. As he noted, “Companies need to create long term economic value, with sound risk management and high integrity. The question is: can we fix those things through government regulation?” The key to fixing how bankers are paid on Wall Street will ultimately come down to a change in the culture of compensation. The Goldman bonuses symbolize the current culture—not only its excesses, but also its dangers, for the financial sector and for the country.