There's been an awful lot of attention focused on the bonus-based compensation of Wall St. and banking professionals, and the controversy is explosive. A big part of the mishugas comes from the fact that a lot of the companies paying out tens of billions of dollars in total bonuses, are receiving massive assistance from US taxpayers, via the TARP and other programs.
Here's a useful precis of the arguments. (You'll notice that a lot of the quotes are from Davos. This is the one week out of the year when all of the business news gets reported out of there, as the global news corps follows the bigshots.)
Now I know as well as anyone that the bonus-compensation model is part of the financial industry's DNA. It's also a part of every sales organization in the world. You reward the people who bring in the money.
But there are some very important points here that do deserve careful scrutiny. Incentive compensation is awarded every year, ostensibly for performance achieved in that year.
But many (most?) investment strategies play out over multiple years. If you put on a trade (like, oh I don't know, making a leveraged bet on increasing US housing values), it could pay off brilliantly one year, and bankrupt your whole firm the next.
Here's a useful precis of the arguments. (You'll notice that a lot of the quotes are from Davos. This is the one week out of the year when all of the business news gets reported out of there, as the global news corps follows the bigshots.)
Now I know as well as anyone that the bonus-compensation model is part of the financial industry's DNA. It's also a part of every sales organization in the world. You reward the people who bring in the money.
But there are some very important points here that do deserve careful scrutiny. Incentive compensation is awarded every year, ostensibly for performance achieved in that year.
But many (most?) investment strategies play out over multiple years. If you put on a trade (like, oh I don't know, making a leveraged bet on increasing US housing values), it could pay off brilliantly one year, and bankrupt your whole firm the next.
Some companies, notably UBS and Credit Suisse, are already establishing
compensation formulas that provide a clawback of bonus comp paid in
prior years for strategies that go bad over time. This is a very
positive thing to do.
Except that finance pros are clever. They'll find ways to disaggregate long-term strategies so they can be accounted for as a series of short-term ones. So while the idea here is good, don't expect the execution to keep pace.
The other thing you'll hear, and this is interesting too, is that it's important for managers to compensate the star performers.
This recognizes the reality that, across a large firm pursuing a range of investment and trading strategies, there are only a tiny handful of stars, and they make most of the loot.
So, you're moved to ask, why the heck don't you retain the stars and fire everyone else. Shhh, you're not supposed to think that way.
Why not? Because out of the small population of stars, there's an even tinier handful of people who turn in stellar performances year in and year out. In fact, the number of those people is close to zero. Trading is a lot like pitching in baseball. There is definitely an A-list, a B-list, and everyone else. But even the A-listers have slumps, injuries, and bad years.
So that makes it hard to lavishly comp only the tiny number of people who made most of your money. The bonus-based compensation model on Wall Street calls for measuring not only hard performance (which you can do among the traders), but also political performance (which is necessary among the "softer" disciplines like investment banking).
Now what you'll hear from the senior managers is that they need to pay huge bonuses to the people in divisions that made money, even if laggards in other parts of the firm lost money. And even if the firm as a whole lost money.
Why? That's the part that I really don't understand.
Is Wall St. telling us that an investment firm is really composed of a lot of small divisions that are independent of each other, from a profit-and-loss perspective? Well, then why are they all such large, vertically-integrated public companies?
Don't tell me that the traders who make money on one particular desk don't benefit from all of the economies of scale, investment banking relationships, and access to deep, liquid capital markets that a large firm has. And don't tell me that the people on desks that lose money did so in spite of everyone else in the firm.
It's a commonplace in industrial companies (and once was on Wall Street as well) that the firm depends on all of its functions. The success of the whole depends on the success of everyone in the firm.
How about we go back to the old-fashioned Wall St. model of small partnerships, where the principals trade and invest with their own money? When the whole firm makes money, everyone wins. When it doesn't, they don't. I think that would be an awesome way to bring some discipline back to the finance business.
Except that finance pros are clever. They'll find ways to disaggregate long-term strategies so they can be accounted for as a series of short-term ones. So while the idea here is good, don't expect the execution to keep pace.
The other thing you'll hear, and this is interesting too, is that it's important for managers to compensate the star performers.
This recognizes the reality that, across a large firm pursuing a range of investment and trading strategies, there are only a tiny handful of stars, and they make most of the loot.
So, you're moved to ask, why the heck don't you retain the stars and fire everyone else. Shhh, you're not supposed to think that way.
Why not? Because out of the small population of stars, there's an even tinier handful of people who turn in stellar performances year in and year out. In fact, the number of those people is close to zero. Trading is a lot like pitching in baseball. There is definitely an A-list, a B-list, and everyone else. But even the A-listers have slumps, injuries, and bad years.
So that makes it hard to lavishly comp only the tiny number of people who made most of your money. The bonus-based compensation model on Wall Street calls for measuring not only hard performance (which you can do among the traders), but also political performance (which is necessary among the "softer" disciplines like investment banking).
Now what you'll hear from the senior managers is that they need to pay huge bonuses to the people in divisions that made money, even if laggards in other parts of the firm lost money. And even if the firm as a whole lost money.
Why? That's the part that I really don't understand.
Is Wall St. telling us that an investment firm is really composed of a lot of small divisions that are independent of each other, from a profit-and-loss perspective? Well, then why are they all such large, vertically-integrated public companies?
Don't tell me that the traders who make money on one particular desk don't benefit from all of the economies of scale, investment banking relationships, and access to deep, liquid capital markets that a large firm has. And don't tell me that the people on desks that lose money did so in spite of everyone else in the firm.
It's a commonplace in industrial companies (and once was on Wall Street as well) that the firm depends on all of its functions. The success of the whole depends on the success of everyone in the firm.
How about we go back to the old-fashioned Wall St. model of small partnerships, where the principals trade and invest with their own money? When the whole firm makes money, everyone wins. When it doesn't, they don't. I think that would be an awesome way to bring some discipline back to the finance business.
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