Blaming Bonuses is Politically Easy but Wrong

A senior aide to a Congressman emailed me regarding the debate on Capitol Hill.  I responded:

Nell Minow knows what she is talking about, but this paragraph on page 5 is the money shot:

But the key is the board. It is unfathomable to me that many of the very same directors who approved the outrageous pay packages that led to the financial crisis continue to serve on boards. We speak of this company or that company paying the executives but it is really the boards and especially their compensation committees and until we change the way they are selected, informed, paid, and replaced we will continue to have the same result. Until we remove the impediments to shareholder oversight of the board, we cannot hope for an efficient, market-based system of executive compensation.

Pay can’t be reformed unless corporate governance is reformed.  Her suggestions above that are “mom-and-apple pie,” but they never get implented because boards are captured by their executives.  What she says on board reform after the aforementioned paragraph is crucial.

Away from that, anyone structuring incentives quickly learns:

  1. Short-term incentives motivate more.
  2. Incentives based on what the employee can control motivate more than those he can’t.
  3. Cash now is preferred to anything else — it motivates more, unless there is tax deferral as a goal, or, inflation of apparent corporate profits, because the issuance of stock does not hit the income statement as a cost.
  4. Some incentives are near-guaranteed because there are goals of not destroying the firm through taking too much risk — those should disappear during a crisis.  In this case, they didn’t but they should have disappeared.

That’s why Wall Street’s incentives were designed the way they were — they motivate to a high degree; that is the culture of Wall Street.  They should have cancelled bonuses because of the crisis — they would have if they had not been bailed out, which the Government stupidly did, and even then did it stupidly.

If the government had merely backstopped the derivatives counterparties, while sending losses to the holding companies until they were insolvent, and running an RTC 2, rather than just handing cash to holding companies, this all could have been avoided.  The systemic risk would have passed — most firms on Wall Street would be in insolvency, and bonuses would not have been paid.

The fault belongs mainly to the Fed and Treasury; they botched their jobs.

Back to incentives — the four points above work best for companies when revenues and expenses of the business are short term in nature.  But when the results of business take a while to develop, like selling a life insurance policy, the accounting gets complex.  So do the incentives.  Life insurance companies typically pay agents most of their compensation in a lump at the sale.  There are limited clawbacks.  Other methods of compensating agents more gradually have been tried, and generally, they don’t work so well with making sales.

But management aren’t salesmen — they should be bright and motivated on their own, or they shouldn’t have their jobs at all.  They shouldn’t need the “immediate gratification” incentives, and should be able to live with the eight reforms that Nell Minow suggests.  This is particularly true for financial companies, the the true results of activity will not be known for years.  Creating longer-term incentive structures will aid stability and improve managment of the firms.  The firms will be less aggressive, and that is good.  Aggressive financials almost always blow up.

To close, if you want to see this happen, corporate governance should be changed, where boards cannot so easily be captured by their managements.  Otherwise, this issue will return.



  • matt says:


    Can you provide insight into how large institutional investors vote proxies?

    My main concern is this–the largest portfolios are index funds. Managers of those funds have to vote proxies for hundreds (even thousands) of companies, depending on the index/sampling of index. In my opinion, it is impossible for fund managers to vote the proxies in good faith (i.e., be familiar with all of the issues for hundreds of companies).

    My assumption is that they just go along with management’s objectives, and this is how shareholders relinquish their obligation of good corporate governance (i.e., they give up their control to fund managers). Is this a fair assessment, or do fund managers really undergo the overhead of researching all proxy issues?

    In other words, is bad corporate governance largely an issue of ownership structure?

  • dlr says:

    “The fault belongs mainly to the Fed and Treasury; they botched their jobs.”

    I think you are being too kind. They only botched their jobs if their goal was the well being of the United States of America. It seems pretty clear that that was not their actual goal. Their actual goal was insulating the well being of the senior executives of Goldman Sachs, JP Morgan, CitiBank, Bank of America, et al. from the natural consequences of their reckless, irresponsible behavior.

    That being the case, Geither, Bernanke, and Paulson did a great job. I am sure they will be suitable rewarded by their grateful constituents – ie, the senior executives of Goldman Saches, et al.

  • dlr says:

    “Criminals would always prefer you to believe they are STUPID rather than GUILTY.”

  • The board problem is a huge one. Board members are typically close personally to the people they are overseeing – how else would they get the job?

    It’s a huge conflict of interest for board members to oversee their golfing buddies, and I don’t see a way around it.

  • el says:


    Changing incentives across the board would’ve certainly reduced bad risk taking and our corporate structure is broken.
    However it seems to me you attack the Obama propaganda and rhetoric rather than actual proposals Volcker made. The devil is certainly in the details but let’s ignore the bonus angle or the “tax” label.

    The idea behind the fee is that given that TBTF already happened and these guys are effectively insured by USG, they should at least pay the proper insurance premium.

    As far as “blaming” proprietary trading. I think you neglect to consider the SIVs and other off balance sheet entities. Even if we agree these weren’t the biggest problems, it is still maddening to see a financial institution (like GS) being able to borrow at discount window rates, lever up and push financial markets in the direction they please.

    Lastly as much as you’d like to blame the Fed, it’s certainly a creation of the banking system cartel. Our politicians aren’t smart enough to create this wealth thievery scheme and the bureaucrats and monetarists just want to keep their job.

    The real problem is a form of corporate fascism

  • RichL says:

    Comp. Committees of Boards use consultants like Towers Perrin to study what are the appropriate comp. levels for their industry. The Board of Directors of a company will assume they are doing their job well, and that they have management that is better than average(the Lake Woebegone effect?)and thus have retained a management worth better than average pay.

    If EVERYONE does this, and they DO, you get a compensation stairway to heaven for ALL companies. All the “above average” firms get better than average increases, which raises the overall average. Compound this exercise repeatedly for 20 + years and you’ll get the absurdly high comp. differences between regular workers and top management.

    That’s why executive comp. consultants are the cause of the executive overcompensation problem.