Compensation Reform - Blog entry (go to blog for 57 comments) - 23 Sep 2009

Compensation Reform

Having already noted the funny part of Paul Krugman’s case for banker compensation reform it’s worth turning to the serious part:

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.

This makes sense to me, though I’m moderately skeptical it can really be made to work in practice.

But I do think it’s worth dwelling on the fact that this really a
pretty odd situation. Who doesn’t the market take care of this problem
itself? It really seems like investors would be reluctant to deal with
financial institutions that are organized this way. It seems like there
was a reason the major investment banks were traditionally organized as
partnerships—partnerships don’t have these incentives, and people
should prefer to do business with institutions that don’t have these
incentives. But the market’s not working like that. And it’s worth
trying to understand why. If regulators start playing cat-and-mouse
with compensation

BLOG Web Address:  http://yglesias.thinkprogress.org/archives/2009/09/compensation-reform.php