Beating Bonuses into Risk Controls

Deferred vesting of stock options is not a new idea—it gained currency amid the corporate scandals that emerged in the aftermath of the late 1990s stock bubble. It appears to be making more inroads at present, in the aftermath of the twin credit and property bubbles.

This growing practice is not confined to Wall Street, but financial firms are the forefront.  Given that bonuses, and hence stock awards, tend to be by far the largest portion of managers’ pay in the financial industry, the restrictions have the potential for curbing bad behavior in the future.

This may be the one useful result of public anger over outsize compensation and the political grandstanding it has occasioned. It could go some way to reduce the perverse incentive created by the government safety net and cheap federal loans, which are in effect an invitation to put the money to use in lucrative but hazardous ways.

Last month Goldman Sachs (GS) announced that its 30 top executives will receive as their bonus only company stock that will not vest for five years.  Moreover, the company can take the stock back “in cases where the employee engaged in materially improper risk analysis or failed sufficiently to raise concerns about risks.”

Other large banks are reshaping compensation along similar lines. Morgan Stanley (MS) instituted claw-backs that allow the firm to reclaim compensation for up to three years if there are losses on certain trading positions, investments or holdings.  JP Morgan (JPM) will repossess the stock bonus of any employee found to have taken excessive risk or not complained about bad risk-taking.

Even hedge funds are under some pressure to delay the vesting of their fee compensation and give back part of the fee if they subsequently lose investors’ money.  Delayed vesting tied to long-term results should discourage excessive risk taking.

There are questions as to who in an organization should be subject to these rules and how to align the individual’s responsibility for long-term consequences with financial penalties—only top executives or all employees who receive bonuses, the person who made the reckless trade or his supervisor as well?  And there are doubts as to how rigorously the rules will be enforced. But the changes are steps in the right direction. Slow as the process may be, better incentives are evolving.

The Federal Reserve apparently approves claw-backs as a way to link pay with risk-taking. Now, shouldn’t similar rules apply also to public sector compensation? The Fed’s own bureaucracy, having generously provided the liquidity for asset bubbles over the years, might need to have its own pay geared to avoiding booms and busts.

Or take the US Securities and Exchange Commission. It would seem to be a good idea to have monetary penalties for a bureaucracy that is capable of so monstrous a failure as letting Bernard Madoff off the hook year after year, despite repeated warnings and even news stories of fraud.

Come to think of it, there could be disincentives against running trillions of dollars in deficits. Say, part of Congressional salaries to be vested in four years, but only if federal spending comes down. That should do the trick.

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