Throwing spit balls at bankers, their bonuses and their golden parachutes is today’s favorite sport for op-ed pundits and ink-hungry politicians. What is the rationale for paying mega-buck bonuses to managers who took so much risk that they now need public funds to bail out their institutions?
The straightforward answer should be “because paying large bonuses is the way publicly-held, large, aggressive banks have been doing business for several decades.” Senior management and boards of directors, in most cases, simply didn’t recognize that once you accept cash from taxpayers via Congress and the U.S. Treasury, the rules of the game change.
Three Issues. The underlying problem, however, is not mega-buck bonuses, but the way in which compensation and risk management have evolved in most large financial institutions. The problem has three dimensions:
1. How to compensate individuals when recent risky and initially profitable decisions turn out, a year or two later, to be financially disastrous. The easy answer is, “make total compensation a function of several years’ performance.” But what, among a variety of issues, if a competitor is prepared to lure away your star performers by promising a signing bonus that compensates them for any future expected payments from their bonus pool or loss of stock options?
2. At another level, when an institution has federally-insured deposits, managements tend to take on more risk. The academic literature is fairly clear on this.
3. Finally, there is the age-old issue of the separation of firm ownership from management. As James Glassman and William Nolan put it in a recent Wall Street Journal op-ed, “bankers need more skin in the game.” When banks are organized as partnerships, like Brown Brothers Harriman, they borrow less and take less risk. That’s because the owners, partners and risk managers are the same people – and have most of their wealth invested in the firm.
Of course, Adam Smith, in “The Wealth of Nations,” said it first – and best:
“The directors of [joint stock companies] being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own . . . Negligence and profusion, therefore, must always prevail, more or less in the management of the affairs of such a company.”
Modern society has struggled with political (“the managerial revolution”) and economic issues inherent in the ownership-management conundrum for decades. It was the intellectual underpinning, as developed by Berle and Means in “The Modern Corporation and Private Property” (1932), for establishing the Securities and Exchange Commission.
Since the current crisis has demonstrated the inherent limitations of the SEC, a strong case can be made for encouraging more partnerships in the financial sector. As Glassman and Nolan summarize the argument:
“In the end, the partnership – not more regulatory intrusion – is an efficient, even elegant, answer to the thorny risk-mitigation problem. Partnerships are less likely to make big mistakes, but, even if they do, their smaller size means they pose less of a threat to the financial system as a whole, and to the taxpayers who have to pay for the clean-up.”
Now there is real regulatory reform - and an answer to the "too big to fail" dilemma!
