Friday, January 30, 2009

Spotlight on Bonuses

It seems like everyone's attention has turned to pay and bonuses at Financial Institutions, so I will at least temporarily join the crowd.

To set the stage, this is just a sampling of the 3,745 news items (according to Google) today alone that dealt with Wall Street bonuses

From What Red Ink? Wall Street Paid Fat Bonuses-NY Times.

"Despite crippling losses, multibillion-dollar bailouts and the passing of some of the most prominent names in the business, employees at financial companies in New York, the now-diminished world capital of capital, collected an estimated $18.4 billion in bonuses for the year.

That was the sixth-largest haul on record, according to a report released Wednesday by the New York State comptroller."

From CBS News:

Obama Pressures Wall Street Over Bonuses -
"President Obama branded Wall Street bankers “shameful” on Thursday for giving themselves nearly $20 billion in bonuses as the economy was deteriorating and the government was spending billions to bail out some of the nation’s most prominent financial institutions...."there will be time for them to get bonuses....Now’s not that time.”
I agree with most of the articles and the President but not for the fairness reasons (although as a signal to customers and employees accepting any bonus seems a horrible move) but rather because what a bonus is intended to do.

Bonuses are meant as rewards used to create the proper incentives. Bonuses that are paid regardless of performance do not do that. And yes I realize that bonuses are way down, but given their performance, they still seem too high.

If you take a second and examine compensation, there are two key things to consider: the level of pay (how much you pay people) and the form of pay (Salary, Bonus, market-based pay etc.). Each is important, but the form much more so.

Level of pay is what attracts and keeps employees (and yes even managers). In the words of Keven Murphy when I took his class, it is what "gets them in the door and what keeps them. Form of pay (and re-evaluations of the level of pay) is what creates incentives and helps to motivate people to do what we want them to do.

Don't think so? Consider this example directly from my class. Suppose you are hired as CEO of a firm and paid a straight salary of $2 million a year. You are told that the pay will never change so long as your firm does not go out of business and you can not be fired. How would you behave? Consider the many agency costs that may arise. Risk taking would likely be scaled way back, debts reduced, dividends and capital expenditures lowered since your main goal is to keep the firm in business so you get your $2 million annuity.

Bonuses and market-based pay are, at least in theory, designed to motivate the employee to do what is in the firm's (and more specifically the shareholders') best interest. For instance, stock options that increase in value with increasing volatility, are a means of making managers less risk averse. Bonuses are similar but more often based on non market factors (either accounting-based or performance based).

Which gets us back to the question of paying Wall Street executives bonuses. If the form of pay is to serve as a proper motivator (that is to motivate them to do what we want), something has to be at risk (Again go back to the example, if I say you get a $2 million bonus no matter how well you do, does it motivate you or is it just another word for salary?).

By any standard, most financial institutions have had a horrible year. To reward managers (which is essentially saying "Good job") is wrong. Indeed, a strong case may be made that the reason why bonuses have been so high over the past few years is not that the firms were doing so well, but that they appeared to be doing so well and the outcome of many of the investments had not yet been determined. Thus some ex-post settlement (IF I remember correctly it was Jensen and Meckling in 1976 who suggested this) whereby the executives give back past bonuses (and not just this year's) is really what should happen.

Now of course it is not going to. There is a movement afoot to get some of this year's bonuses back at firms who got government bailouts but even this faces very long odds.

While it may be a disappointment (in the spirit of no matter how many times Charlie Brown goes to kick the football, I always hope that Lucy will come around this time and do the right thing and let him kick and I am disappointed when Lucy pulls it away), it really should not be a surprise to anyone that managers will largely get their bonuses even if the bonuses are smaller than in the past (remember they probably should not have gotten the past ones at all if the true value of their investments were known then).

As Garvey and Mibourn (2003) showed managers tend to get rewarded when things go right (good luck?) and yet are not penalized when things go wrong (bad luck?). I somehow doubt that this time around will be any different Charlie Brown will still end up on his back and managers will still look out for themselves and not shareholders.

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