Another Approach to Compensation

The
problems with the traditional model of banker compensation are well
known. To simplify, if a trader (or CEO) is paid a year-end cash bonus
based on his performance that year (such as a percentage of profits
generated), he will have an incentive to take excess risks because the
payout structure is asymmetric; the bonus can’t be negative. That way
the trader/CEO gets the upside and the downside is shifted onto
shareholders, creditors, or the government.

I was talking to Simon
this weekend and he said, “Why a year? Why is compensation based just
on what you did the last year? That seems arbitrary.” When I asked him
what he would use instead, he said, “A decade,” so I thought he was
just being silly. But on reflection I think there’s something there.

Most approaches to solving the compensation problem focus on
changing the way the bonus is paid out, not the way it is calculated in
the first place. Many people think that bonuses should be paid out in
retricted stock that (a) vests over five years and (b) cannot be sold
for some period of time after it vests. (This is already the case for
top executives–but not most employees–at many big banks.) The goal here
is to tie the eventual payout to the long-term performance of the
company, via its stock price.

This is better than all cash, but it still has a few problems. For
one, the top executives at Bear Stearns and Lehman Brothers already had
this type of bonus payout, and it didn’t help.
For another, tying managers’ incentives to shareholders isn’t
necessarily what you want when it comes to highly leveraged banks,
since shareholders also have the incentive to take on too much risk
(since they can shift losses to creditors or the government). (For this
reason, Lucian Bebchuk has suggested tying long-term compensation to a
basket of securites that includes not just common stock but also
preferred stock and some kinds of debt.) In addition, this type of
payout structure wouldn’t change the incentives for individual traders,
since their bonus is calculated based on the one-year performance of
their individual book, and then paid out depending on how the entire
company does; even if those trades blow up the next year, chances are
they won’t affect the stock price that much.

Clawbacks in future bad years are another idea, but at least as
proposed by the Obama administration, I think they would only apply in
cases of material misrepresentation. Also, it’s hard to claw money back
from people who have left your company. In the business world
generally, sales compensation agreements often have clawback
provisions, but it’s generally understood that you’re not going to sue
your former employees to collect on them. (Besides, often the money has
already been spent.)

Simon’s idea (at least as I’ve thought it out) is to change the way the bonus is calculated in the first place, instead

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