Thursday, February 05, 2009

Executive Compensation
Category: News and Politics

The more I hear about the specifics of the new bailout/stimulus package, the more I fear that we are squandering a once-in-a-lifetime opportunity to make badly needed changes in our fundamental economic arrangements and are instead indulging in an expensive exercise in populism and pork.

I suppose in any spending bill of this size, a fair amount of pork is unavoidable, but the blatant (and misleading) pandering on an issue like executive compensation is not only a distraction from more important issues, but it is also dangerous.

Prior to the collapse, the best and brightest in the banking industry could hope to earn millions (or even tens of millions) if they made it to the top of their field. Disregarding for the time-being the ethical/moral dimensions of the pursuit of mega-riches, let’s consider the practical consequences of capping executive compensation.

In a society that worships fame and fortune, the financial markets represent one of the only fields in which those not blessed with exceptional athletic abilities or good looks can hope to achieve success comparable to that of professional athletes or movie stars. For an ambitious college senior surveying the landscape of career options, there is an array of possible choices. Those who desire financial comfort but who also value stability and job-security might choose a career in law or accounting. Success in these fields is more attainable than in banking, but compensation is commensurately lower. A good accountant might make a couple hundred grand a year, never a hundred million.

Again, my point is not to judge whether it’s a good thing for the smartest members of our society to be motivated by the hopes of earning big bucks. The point is that the potentially outsized rewards ensure that the banking industry is able to attract people of the highest caliber.

If we now arbitrarily pass a law stating that bank executives’ compensation cannot exceed $500,000 per year, we will drastically affect the incentive structure facing the talent pool available to the industry. If a top-tier financial professional is faced with the option of running a bank with a salary of $500,000 or working for a hedge fund and earning $10 million, its not hard to see that banks will be unable to recruit and hold onto the most talented people. It is beyond foolish to expect that we can make such a change without causing a deterioration in the quality and performance of banking executives.

Furthermore, while the amounts of money earned by top banking executives seem excessive relative to what people earn in other fields, they are not out-of-line in terms of their impact on the bottom lines of their companies. Let’s imagine a bank that makes a profit of $5 billion and pays its CEO $100 million. If having the very best person in the position of CEO is responsible for a 10% increase in profitability (relative to a less talented CEO), the impact of the star-CEO is $500 million, so paying $100 million for his services is a good corporate decision. (Likewise, in an environment where we are seeing banks lose tens of billions, if a top-notch CEO is capable of paring losses even by a few percentage points, it is a good decision for the corporation to pay that CEO whatever it takes to prevent him from accepting some other highly lucrative form of employment.)

Yes, it is infuriating to see bankers taking expensive boondoggles to Monte Carlo or auto execs flying in corporate jets while their companies hemorrhage money, but this should not cause us to hastily make policies that will only further impair the ability of these corporations to recover. Simply capping salaries at $500,000 will only guarantee that we end up with less talented executives trying to deal with the most difficult banking environment of our lifetimes.

All of this is not to say that executive compensation is not in need of fundamental reform. But the simpleminded, populist fix of arbitrarily capping salaries is not the right solution.

The most glaring problem with compensation in the financial field (as well as others) is that tying bonuses to a company’s reported earnings in any given year creates dangerous incentives for executives. On one hand, it rewards reckless risk-taking, since if a gamble pays off the executive responsible can make a pile of money, while if it doesn’t, he can just walk away and get another job. Additionally, it creates incentives for executives, auditors, and ratings agencies to present fraudulent numbers in order to boost short-term rewards. Many of the problems that currently threaten the very survival of the country’s largest banks stem from these pay-related incentive issues. But to just deal with a complex and thorny issue with a simplistic and politically expedient fix like capping salaries at $500,000 is foolish and potentially harmful.

One Response to “Executive Compensation -by Josh”