Limits on Executive Comp: Where I Think We’re Headed
Potentially to a good place, surprisingly enough.
The instinct behind the new restrictions on executive comp for banks receiving exceptional public assistance is sound enough: people on the public payroll shouldn’t be making $10 million per year.
The regulation, as far as I can see from a quick read, will obviously need to be fleshed out, and much of this will likely happen in a legal and regulatory back-and-forth based on individual cases. This will not be done in isolation, but will be closely bound up in a broader, unpredictable process of financial regulation over the next several years.
Ultimately, I think that the right regulatory framework for the U.S. financial sector is a modernized version of something that emerged from the Great Depression. My vision is one of, roughly speaking, tiers of financial alternatives of increasing risk, volatility, and complexity available to any appropriate investor. Almost any non-coercive transaction should be legally permitted in some context. The tiers should be compartmentalized so that a bust in a higher-risk tier doesn’t propagate to lower-risk tiers, and the government should be rigorous about allowing failure in the higher-risk tiers. I’ve called this idea “Walls, not Brakes”.
Something like this should provide the benefits of better capital allocation, continued market innovation and stability. Of course, such a vision will never be fully realized. Markets constantly undermine such regulatory schemes. There is no substitute for ongoing, democratic evolution of regulations, unfortunately usually in response to failures.
The proposed limits on executive pay, if they have any teeth as they are really implemented, are likely to have several knock-on effects. People who are able to make millions per year in a competitive market will tend to drift away from these firms (even though these restrictions only apply to senior executives, they would change the compensation culture for the firm as a whole), and form new asset management firms, M&A advisory boutiques and so on. Along with limits on comp, the government-sponsored entities will have restrictions on investment behavior imposed by the government – they will not be issuing a lot of credit default swaps. This will mean these large institutions will be unable to offer very high rates of return as compared to the firms that don’t take government money, but will offer safety.
Think of what we would then have: a tier of government-supported, low-risk / low-return big commercial banks that are run by competent, but not exceptional, bankers who are paid like senior civil servants; and another tier of high-risk / high-return financials that look like the “old Wall Street” that everybody says is dead. This is a world of walls, not brakes. When this tiering is in place, the government should be able to get out of the business of doing things like directly setting executive compensation.
The downside risks to how this might develop are numerous. One is the potential that this low-risk tier will be literally a government-run utility for a long period of time. Another is that government intrusion on behalf of the government-supported banks is so extensive that it is impossible to compete without government assistance. There are surely others.
It seems to me that the key political debates on this topic are most likely to be around these kinds of issues. I think that the tiered vision for financial regulation of I’ve put forward makes sense, and is rough roadmap for transitioning out of direct government operation of businesses as rapidly as is prudent.
I like this proposal.
People who are able to make millions per year in a competitive market will tend to drift away from these firms (even though these restrictions only apply to senior executives, they would change the compensation culture for the firm as a whole), and form new asset management firms, M&A advisory boutiques and so on.
What confuses me – as you allude to there – is the executive ability to indeed walk over to other companies and make incredible amounts of money even though they wrecked their own companies. If you run your White Castle’s franchise into the ground, you aren’t going to get floated a Wendy’s ones!
But this happens , while laid off factory workers who have sent no signal as to their ability will be very lucky to recoup 70% of their salary. I can explain it to myself, but not with the idea of a competitive market for executives.
— Rortybomb · Feb 4, 07:56 PM · #
Your proposal sounds a lot like the old Glass-Stegall Act. I wonder if it rally is possible to keep those “walls” up, particularly in the face of global competition.
— rtc · Feb 4, 09:15 PM · #
rtc:
Yes, this is what I meant by an updated version of something that emmerged form the depression.
No, not indefintely. Eventually technology, politics, practice and so on allows entities to do what we just saw happen, which is to combine high-risk returns with regulated backing (e.g., AIG issuing a massivve volume of CDS). That’s what I meant by saying that markets constantly undermine such strcutures and a democratic political process has to keep rebuiling them (as we’re hopefully seeing right now).
— Jim Manzi · Feb 4, 09:37 PM · #
i said something very similar on scienceblogs, so i feel good as someone who actually knows something about this area seems to be thinking in the same direction
on another note, here is an effect which i think is important: more people with science & quant. skills will stay in science & tech, as opposed to chasing the big bucks in financial “engineering.” i think that the productivity gains in modern economies are driven by technology, and that innovation needs human capital inputs. recently a lot of the “smartest-guys-in-the-room” were moving to wall street to leverage their skillset into mucho remuneration (yes, i know it happened in the past, but it seems to increased of late). now that that option is removed perhaps they’ll start generating value for society as opposed to maximizing the capture of value for themselves ;)
— razib · Feb 5, 01:57 AM · #
can someone remove the markdown? (i have no idea what i did)
— razib · Feb 5, 01:58 AM · #
Done, hopefully correctly.
— Jim Manzi · Feb 5, 02:41 AM · #
Second paragraph restored. Textile turns surrounding hyphens into strikethrough.
— Matt Frost · Feb 5, 02:59 AM · #
Thanks, Matt
— Jim Manzi · Feb 5, 04:00 AM · #
Jim,
What you are describing seems to me to be almost exactly the opposite of the current case, a case that has evolved into what it is for a reason, and that reason is inherent in human nature and politics. Once people achieve political office the gravity of the situation almost inevitabley bends their character in the direction of money. And the people who would lose most by your proposal are exactly the ones with the most gravity.I like the idea a lot though.
— cw · Feb 5, 05:57 AM · #
Maybe it’s late and I’m tired, but I haven’t understood why:
1) We (the USA) own or partly own these firms
2) Our ROI depends upon their performance
3) We want to force them to hire lesser performers by capping their salaries (as noted, this will trickle all the way down)
4) This is due essentially to: a) A desire for vengeance combined with b) an apparent desire to uproot the financial world in 80 days or less (Faster Obama, Stimulate, Kill!) c) with zero reflection outside the Internet free-advice-circuit OODA loop
5) The taxpayer interest comes last.
“Walls, not brakes.” The highways would be an interesting way to travel under that philosophy.
I suppose there is no interest in allowing banks to recognize and reject bad risk, i.e. burning the CRA, neatly wrapped around its authors?
While we’re at it, SOX has steadily been directing business to London from NYC. Don’t suppose we could back that out?
But no, don’t stop tasing them, bro!
Personally I hope the mortgage crisis will continue till New York real estate is affordable; however, my private vengeance against my landlord can wait upon the greater good.
— Nichevo · Feb 5, 08:31 AM · #
@Rortyb: Without addressing Jim’s specific claims, let me just generally comment that the answer to your confusion is that we are dealing with a least-bad alternative. A 100% efficient meritocracy would be fantastic, and about as likely as flying unicorns. The best we can really expect is that the best companies tend to attract the best resources (labor, management, assets, etc.). Yglesias’ meritocratic contrapositive is really an exception that proves the rule: I’m not a business junkie, but it seems that Sears is not the sort of robust, dynamic corporation that can afford to hire top-tier executive talent.
It seems fruitless and somewhat petty to point to meritocratic capitalism’s inefficiencies without investigating whether any alternative would be more efficient. That so many of these losers are going to be kept afloat by the government’s dole strikes me as a far greater inefficiency (if not injustice) than a single hapless Lehman executive adjourning to a corporate dinosaur like Sears.
(But given that we are going there anyway, Jim’s proposal makes some sense, speaking of least bad alternatives.)
— Blar · Feb 5, 03:14 PM · #
I would also note, if it’s not pandering, that money paid to these people does not go up in smoke; that, in fact, it does circulate in the economy.
If it is the butcher at Lobel’s instead of at Shop Rite, Kona coffee instead of Maxwell House, Barney’s instead of SYMS, or even a French bizjet (still serviced by US mechanics and airports) instead of a Cessna: still, real people make a living in their economy. And that rolls downhill to the mid-level guys making, oh, $80-$120K and deciding on what they can afford for Valentine’s Day, and, yes, down to the mailroom.
And, more to the point, if you will not be hiring star types for management, you will tend to promote from within. This sounds good, but in this particular case, unless you exonerate the rank and file and blame all on the CEOs, you will just be promoting from the same corporate culture that spawned the mistakes. No escape from the Peter Principle. No cleaning house and bringing in your talented team from the other place.
Money is a tool – all you are saying is “Don’t use such a big hammer.” Perhaps the carpenter knows better than you, even if he did bend a nail.
IMHO envy is at the root of all this. I would much rather socialize the pay of lawyers athletes and actors, now these people are obviously worthless. There is a market failure, if you like.
— Nichevo · Feb 5, 04:46 PM · #
The problem with the walls idea seems to me that unregulated high-risk funds have the potential to crash the economy again. They can borrow and lend so much money and are still subject to irrational or rational bank runs just like any bank. Any class that can borrow trillions in the short term and lend in the long term is a speculative bubble or potential bank run waiting to happen.
How can the government ensure that “a bust in the high risk tier doesn’t propagate to the low risk tier”? Only by ensuring that the organizations in the high risk tier never become “too big to fail”. But as we learned from AIG (which was brought down by a small overseas unit), even a few traders can borrow enough to become too big to fail unless there is someone looking over their shoulder. Ensuring that this doesn’t happen is the point of government regulation.
As long as banks are regulated to the point that they are never too big to fail, then there doesn’t have to be any regulation of the salaries, thats between the managers and the shareholders. But a bank that is too big to fail is already effectively backed by the government even if there is no explicit guarantee or loan. In return for even my implicit guarantee, I, as a taxpayer, want some assurance that the salaries will not be so large as to cause the bank to fail.
This assurance could be in the form of a salary cap. There are others such as putting the bonus in stock which can only be sold in five years or a realistic threat to can the top management in the event of a bank failure. But it seems that instead of losing their jobs, the management is finagling retention bonuses.
Jim’s view of allowing all interactions between willing adults just breaks down with the concept of “too big to fail”. My neighbor and his friend are free to have an argument on their own private property, but they are not free to use nuclear bombs whose fallout would sterilize mine. Banks and their customers are free to do what they want up to the point that their failure causes me to lose my job.
As far as meritocracy, just because someone was paid a lot of money during a bull market does not mean that they are smarter or more deserving than the rest of us. They could have been luckier, or they could have over-leveraged to the point where they would have been dangerous. The top managers who did the latter are the ones looking for a job now. The top managers who properly estimated risk and hedged appropriately, who set up controls within their firm to prevent rogue units are the ones who today don’t need a government bailout. And so, properly, they won’t have to submit to a salary cap.
Its also hard to make the case that even top bankers are smarter than, work harder than, are better trained than, or provide a greater societal benefit than top surgeons or scientists and hence deserve an order of magnitude greater pay. $500k is plenty of money!
— David · Feb 5, 04:54 PM · #
That’s a rather loaded premise. The history of the corporate world is full of former giants who were allowed to fail with little ill consequence. I just quickly read up on the Barings Bank collapse of 1995, and while tragic, the result was that other banks dismembered it for parts, and the world economy continued. This was one of the oldest, most established banks in England, and its failure was not catastrophic to the economy at large.
I think everyone agrees that a component* of the crisis was the collapse of Fannie Mae and Freddie Mac, which of course were “effectively backed by the government,” but the problem wasn’t their size. It was the distortion that being “effectively backed by the government” involved, a distortion which their size hardly mandated.
*Some would say the linchpin, while others paint it as one of many unrelated causes, but no one denies it was significant.
— Blar · Feb 5, 05:59 PM · #