“Crazy Compensation and the Crisis”

Alan Blinder urges “corporate boards of directors and, in particular, of their compensation committees” to create compensation plans for financial firms that discourage excessive risk taking:

Crazy Compensation and the Crisis, by Alan Blinder, Commentary, WSJ: Despite the vast outpouring of commentary and outrage over the financial crisis, one of its most fundamental causes has received surprisingly little attention. I refer to the perverse incentives built into the compensation plans of many financial firms, incentives that encourage excessive risk-taking with OPM — Other People’s Money.

What, you say, hasn’t huge attention been paid to executive compensation…? Yes. But the ruckus has been over the generous levels of compensation,… not over the dysfunctional incentives…

Take a typical trader at a bank, investment bank, hedge fund or whatever. … Unfortunately, their compensation schemes … offer.. them the following sort of go-for-broke incentives when they place financial bets: Heads, you become richer than Croesus; tails, you get no bonus, receive instead about four times the national average salary, and may (or may not) have to look for a new job. …

[L]et’s consider the incentives facing the CEO and other top executives… For them, it’s often: Heads, you become richer than Croesus ever imagined; tails, you receive a golden parachute that still leaves you richer than Croesus. So they want to flip those big coins, too.

From the point of view of the companies’ shareholders — the people who provide the OPM — this is madness. … Traders and managers both want to flip more coins — and at higher stakes — than shareholders would if they had any control, which they don’t.

The source of the problem is really quite simple: Give smart people go-for-broke incentives and they will go for broke. Duh.

Amazingly, despite the devastating losses, these perverse pay incentives remain the rule on Wall Street today, though exceptions are growing. … These wacky compensation schemes have puzzled me for nearly 20 years. … But the issue could be considered an intellectual puzzle until the bottom fell out. … after an orgy of irresponsible risk taking… [T]he consequences for the real economy have been devastating. …

What to do? It is tempting to conclude that the U.S. (and other) governments should regulate compensation practices…. But the … executives, lawyers and accountants who design compensation systems are imaginative, skilled and definitely not disinterested. Congress and government bureaucrats won’t beat them at this game.

Rather, fixing compensation should be the responsibility of corporate boards of directors and, in particular, of their compensation committees. These boards, … are supposed to represent the interests of stockholders, not those of managers. … The unhappy (but common) combination of coziness and drowsiness in corporate boardrooms must end. … For example, top executives could be paid mainly in restricted stock that vests at a later date, and traders could have their winnings deposited into an account from which subsequent losses would be deducted.

Comprehensive reform of the financial system will probably take years. The problems are many and complex, and the government’s to-do list is not only long but also a political minefield. Yet fixing compensation incentives does not require any government action. It can be done by financial companies, tomorrow. Too bad they didn’t do it yesterday.

But how is the board of directors chosen? See also:

The SEC’s Proxy Access Proposal, by Lucian Bebchuk: The Securities and Exchange Commission voted last week to ask the public to comment on a proposal to let shareholders place director candidates on the corporate ballot. The adoption of such a rule would be a useful step toward the necessary reform of corporate elections. …

Originally published at Economist’s View and reproduced here with the author’s permission.