The announced $2 billion (and counting) JPMorgan trading losses are serving as a catalyst for a national discussion on the effectiveness of banking reforms enacted to date. But it risks getting mired in a debate on the minutiae of exactly what type of trade drove the loss. Would it have been classified as a proprietary trade or not? The complexity involved in trying to identify and prohibit the type of trade is akin to trying to remove a certain color of water from a swimming pool. Instead we should focus on how much water is in the pool overall: that is, how much risk the large US banks should shoulder in total and how best to manage that risk.
An important driver of bank risk is a bank's senior management risk tolerance -- which quickly leads to how their compensation can affect it. The changes made since the downturn have been for managers to take more of their compensation in the stock of their bank and be required to hold it for longer periods of time.
In changing their compensation in this way, we are at best conducting a behavioral experiment and at worst heading in exactly the wrong direction. Here's what we know: equity investors are risk-tolerant and increasingly short-term in their outlook. When investors buy stocks, they are typically focused on how much the stock can rise, and understand that the company must take on risk in order to drive that. Who can forget stockholders drubbing Phil Purcell out of Morgan Stanley in the run-up to the subprime crisis for delivering insufficient earnings growth, when in hindsight his risk-averse stance was precisely the right one for the times? And who can forget the resulting lessons learned by other bank CEOs, that eschewing available growth risked their jobs?
As for loading senior executives up with more stock, who would argue that Dick Fuld's mistakes at Lehman Brothers were because the several hundred millions of dollars of stock he held were not enough? Indeed, equity investors' goals of "stock price performance now" arguably flies in the face of the broader societal need for banking safety and soundness.
But maybe having executives required to hold the stock longer will cause them to take on less risk. But maybe not.
Here's something else we know. Fixed income investors are risk-averse. For them, upside on their investment is limited, since the most they receive back at maturity of the instruments is 100 cents on the dollar. Thus they are laser-focused on avoiding risks that will cause losses, because they don't get any more than that 100 cents if the bets win.
As I outline in the June issue of the Harvard Business Review, if our societal goal is to reduce risk in banks, bank boards should compensate management teams not just in the bank's equity, but a combination of the equity and fixed income instruments of the institution.
Here is how it could work: If a bank is funded with $1 in debt for every $1 in equity (a relatively unlevered position for a bank), executive compensation would mirror that; if the stock component of an executive's compensation today is $2 million, then he would be paid in $1 million in debt and $1 million in equity. The executive would maintain a healthy risk appetite, giving some good amount of his focus to increasing the value of his $1 million of stock.
If the capital structure of the bank shifted to, say, $40 in debt for every $1 in equity (a hugely risky position, circa Lehman 2007), then the same executive's $2 million would be paid $1.95 million in fixed income instruments and $50,000 in equity. As the bank's capital structure becomes riskier, the executive would likely become much more risk averse, focusing more on maintaining the value of the $1.95 million in bonds, rather than increasing the value of the $50,000. This provides a natural hedge.
The value of such a compensation system is not that it will necessarily make the CEOs of these firms behave any differently (though it may), but that as it spreads through the management ranks, it will impact the risk tolerance of the executives running the businesses, the trading desks and the trading positions themselves (including JP Morgan's "Whale"). The entire organization will shift naturally from one of looking to take on more risk to one of looking to reduce risk as financial leverage increases, in opposition to the risk profile of the bank itself. In doing so, the interests of the bond holders, deposit holders and the public at large will be more aligned with the management team. And, counterintuitively, equity holders will be better off, through a cycle, to have their interests less aligned with bank management teams than they appear to be today.
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Robert Reich: Why The Economy Can't Get Out of First Gear
Meltzer knows what he's talking about.
http://online.wsj.com/article/SB10001424052702304192704577405821765336832.html
The CEO’s biggest payday in both scenarios is to make the stock perform well. Under Ms. Krawcheck’s proposal, the CEO would get less if the stock performed well, but could actually collect more if the stock performed poorly.
If a Company does well, the CEO’s stock performs well, and bondholders are paid 100 cents per dollar.
If a Company performs poorly, the CEO’s stock does poorly, and bondholders are paid 100 cents per dollar.
If a Company does so poorly that it goes bankrupt, the CEO’s stock is worth zero, and bondholders are paid less than 100 cents per dollar.
Whether the CEO’s stock-based compensation is just stock-based or a combination of stock and bonds, the CEO does best when the stock performs well. In the worst case, the CEO’s stock would be worthless, but his bonds are likely to be worth something.
Let the former shareholder suits begin.
Integrity is what is needed for the entire American people.
Right now our system allows bankers to take any risk they choose, they pay the same insurance anyway and the government pays for their mistakes. There's no risk to them for taking risks with their money.
Equity investors do tend to be risk-tolerant. But (theoretically at least) it's not mostly that being an equity investor makes people risk-tolerant. Mostly, people hold equity because they're risk-tolerant.
If we want to make banks less risky, we should take them out of the whatever-benefits-the-shareholder model of corporate governance, and regulate them in the public interest. Equity takes the first hit when there's a loss, so it has a role to play in making management risk-averse. If we want to make bank managers risk-averse, we should pay them with a package they're required to hold several years, that's long the stock and short a call option. In other words, if the stock goes down a couple years later they lose, but if the stock goes up manager doesn't gain. Instead the counterparty exercises the call and the manager only gets the strike price.
There's a role for bonds, too. Bonds lose value only if the company completely can't pay. Stock loses part of its value with even small losses. But once it's worthless it's worthless. Bonds lose more value on bigger losses after stock is worthless.
Part of the Glass-Steagall act was to distinguish between commercial banks and investment banks. The FDIC only applied to commercial banks.
The Glass-Steagall act was not repealed. We still have the FDIC. What was repealed was the distinction between commercial and investment banking, thus putting the taxpayer on the hook for even more of the banks' losses.
This is NOT deregulation. This is NOT capitalism. It is what happens when people are fooled into believing that politicians and regulators do what they do for our good and not their own.
A tiny group of political and financial elite have asserted for themselves the exclusive privilege of creating money out of nothing. Thanks to our K-thru-12 government indoctrination centers, an army of well-rewarded court apologists, and an obedient establishment media, we are programmed to believe that these elite wield this incredible power for our own good.
First things first, you know?
Another way to put it - if an exec gets partially paid with the same stuff - good or bad, that it holds, then the exec might think a bit more carefully about what types of investments he pushes the firm into.
BTW, I worked at the same firm which used to have an umbrella logo that you were at; you were one of very few execs that employees had any inclination to trust back then.
Why do CEOs and other top executives of large corporations today need such extraordinary compensation packages (massive salaries, immense perks, vast stock grants/options) to motivate them to merely do their jobs? I know how it happened, of course -- senior officers have too much say in who sits on their boards, interlocking boards where officers of A sit on the board of B and officers of B sit on the board of A, and rigged "surveys" that reinforce the notion that "I have to be given more or I'll leave".
Other corporate employees are expected to do their jobs without such extraordinary compensation. Sure, a CEO has a great deal of responsibility, so pay him/her a healthy salary (say, up to 100 times average or median employee salary). But, if he/she isn't doing the job, then fire him/her just as he would a lower-level employee.
If we could stop the attitude that "high executive" is the same as royalty, things will start to change for the better.