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Follow Up: From The I Told You So Desk On Executive Compensation…

June 25th, 2009 · 38 Comments
Follow Ups · Incentives · Policy

A couple of weeks ago, the Obama administration named attorney Kenneth Feinberg as compensation czar. (I must point out that it’s really not helpful to allow someone to be referred to as a “czar” when you have a bunch of people worried that you are trying to turn the U.S. into a socialist state. Just saying.) Feinberg’s job is to set compensation for top (as in the food chain, not as in performance) employees at firms receiving bailout money from the government. My initial thoughts:

  • How on earth did I miss the application process for this position? It seems right up my alley.
  • Why was an attorney chosen rather than an economist? There are plenty of very bright economists who specifically study contract theory and incentives. (My vote, for example, would go to Brian Hall for his work on executive compensation.)

I am not in principle against the government placing restrictions on bailed-out firms, since it seems only fair that the bailout funds could come with some attached strings. This stance is, of course, based on the assumptions that 1. The firms being bailed out made unintelligent choices in order to get themselves in trouble (and weren’t just victims of happenstance or bad luck), 2. The corporate oversight was lax enough to allow bad policies to fly under the radar, and 3. The firms knew in advance about the restrictions they had to agree to in order to take the money. That said, these attached strings should be designed intelligently so as to not strangle the compenies they are aiming to fix. I wrote before about how the $500K pay cap for CEOs of bailed-out firms was likely to be counterproductive. I stated two main points:

  • The limits were going to lead to a “flight of talent” to firms that were not receiving bailout funds and could thus offer higher compensation.
  • The limits were going to result in firms gaming the system to maintain their current levels of pay.

Apparently the compensation czar didn’t read the memo that I sent. (When will people learn? Sheesh.) From what I gather, limits on bonuses were one of the pieces of the czar’s plan for fixing broken companies. How do I know this? Because I read the following headline:

Citi Boosting Salaries to Offset Lower Bonuses

Excuse me for a moment while I register my lack of shock. Some highlights:

“Citigroup Inc. is increasing base salaries for many of its employees — reportedly by as much as 50 percent for some workers — as it restructures its compensation program amid new restrictions on bonus payments.

The increased salaries will offset lower bonuses, according to a person familiar with the matter who requested anonymity because the plans have not been made public. The higher salaries are not the equivalent of annual raises, the person added.

Citi faces restrictions on bonuses as part of a new government compensation oversight plan because the bank received bailout funds from the Treasury Department.

By shifting the mix in compensation packages, it will allow Citi to pay most employees as much as they received in 2008 while adhering to bonus caps.

‘Citi continues to examine ways to ensure its employee compensation practices are competitive in this very challenging market environment,’ Citi said in a statement Wednesday. ‘Any salary adjustments are not intended to increase total annual compensation, rather to adjust the balance between fixed and variable compensation.’

A New York Times report published Wednesday said some employees salaries will rise by as much as 50 percent because of the change in compensation structure.”

“The Obama administration has blamed compensation plans for encouraging excessive risk-taking that pushed the financial services sector into chaos last year.”

“Aside from the boost in salary to offset the lost bonuses, Citi is also planning to award new stock options to employees to help ensure they remain at the bank, according to the Times report.”

At least Citi is smart enough to recognize the possibility that people would leave if Citi stops paying them, and I would argue that it’s doing the best it can within the regulatory framework. But is the regulatory framework a smart one? As noted above, there is concern that variable compensation leads to excessive risk-taking. I’m not sure that I agree- in order for excessive risk-taking to be a concern, executives would have to either be protected from downside risk or be very risk-loving. Hm. When I put it that way (and think about bonuses in the form of stock options), it doesn’t seem so farfetched. Regardless, the purpose of variable compensation (read, bonuses and the like) is to align the incentives of managers and shareholders. Shifting to a more salary-heavy structure *may* discourage risk-taking (if you’re paid a salary, why not take the risks that seem interesting? It’s not like your butt is on the line.), but it will also likely discourage general usefulness and productivity. After all, the concept of variable compensation came about because a fixed salary wasn’t providing proper incentives to managers, so wouldn’t we want to figure out a better way to incent rather than just taking a step backwards?

I will acknowledge that the academic literature on incentives states that sometimes it’s better to not give an incentive at all than it is to give an incentive for the wrong thing or give an incentive that is too norrowly defined- after all, you very much get what you pay for. But what do you get when you pay for nothing?

Tags: Follow Ups · Incentives · Policy

38 responses so far ↓

  • 1 Barbara Horne // Jun 25, 2009 at 1:34 pm

    It is an intersting situation. I have no problems with firms that received bailout money having salary restrictions as long as they have the option to pay the money back and avoid the restrictions.

    Compensation is not the only problem with Wall Street culture, there is a general focus on the bottom line that negates implications to society (actually that may be the problem with American Business culture in general)

    anyway…a slightly different thought…
    I wonder if the aim is actually fix the companies or slowly allow the market to drive them out of business because the possible impact of a restrictions are known (I have no problem with the latter by the way)

  • 2 econgirl // Jun 25, 2009 at 3:46 pm

    Also, if you ever doubted that the American public cares about fairness, check out the comments on the following article:

    http://finance.yahoo.com/tech-ticker/article/yftt_269189/Citi-Catch-22:-Why-Taxpayers-Should-Support-Higher-Salaries-at-Bailed-Out-Banks

    When I was little, my mom used the phrase “cutting off my nose to spite my face” fairly often. (Okay, maybe she still does.) I am curious as to whether people are really willing to endure the consequences of a company like Citi going under because that’s what’s “fair”.

    One main theme in the comments is that it’s wrong to raise salaries for current employees because they are the ones that screwed up in the first place. The people writing these comments ignore two important points:
    1. It’s not like Citi is going to be able to hire better people with inferior compensation, so the general compensation issue is unavoidable.
    2. Even if the people currently at Citi are not the best, there is an amount of firm-specific human capital that they hold. In this way, Citi would suffer as a result of substantial turnover even if it got objectively better employees.

    For a definition of firm-specific human capital, see here:
    http://www.britannica.com/EBchecked/topic/1300696/firm-specific-human-capital

  • 3 econgirl // Jun 25, 2009 at 3:48 pm

    @ Barbara’s last point: ooooooh, maybe Obama is an evil genius. 🙂

  • 4 Johnny Debacle // Jun 25, 2009 at 4:26 pm

    “Why was an attorney chosen rather than an economist?”

    This bothers me the most. I know lots of lawyers and they are all (some of them) fantastic people and I treasure all (some of their) friendships dearly. But they aren’t magicians, they aren’t imbued with the ability to be experts at…everything. They aren’t taught that at law school.

    But at least this guy has some experience valuing tricky things in the past.

  • 5 Barbara Horne // Jun 25, 2009 at 4:40 pm

    I can talk about this stuff ALL day seriously. It is very scary. I have been pushing this concept that we need to “Stress Test” the American Financial System. Sounds large, but I feel it is so difficult to address some of these issues without really understanding what “more” of our options are (I know we can never really know all of them but still…) For example, I feel like acquisitions would be the ideal answer, but of course “so called” toxic assets and tight credit markets are prohibiting a lot of that.

    I mention that for several reasons (one being that I think I just needed to get it out again :-))
    But, more importantly, I agree with your first point. However, I think that emotion, lack of Econ/Bus/Fin knowledge and the media have people looking at things from a non-consequential perspective. ex. people were supporting taxing AIG employees at 90% which for MANY reasons(political, legal, Econ-incentive etc. ) doesn’t sound like the best approach to me.

    But, people are so emotional and limited in knowledge that they may not be looking at the possible impact of such decisions.

    Unfortunately some of these people are decision makers.

    In terms of your point on “firm-specific capital” I agree with that as well. I was recently explaining something similar to someone in terms of AIG etc. and why they should not just let ALL the executives go. I tried to give the arguments that we live in a “leadership” culture so just cutting off the top will leave serious lack of leadership and strategy…gaps and inefficiencies and it takes time for people to learn a new job and in the mean time the existing processes will be falling apart.

    I looked at the comments they are scary and funny. I watch “tech-ticker” from time to time. Unfortunately I think people are going to end up making some “problem” decisions not understanding that fairness may be more gray then Black or White when it comes to cleaning up this mess.

  • 6 Sam Kinney // Jun 25, 2009 at 5:09 pm

    My problem with compensation micro-management is that the real world is far more creative than “regulators” as Jodi’s post points out. How transparent can this all be to Congress? Limit bonuses and the compensation balloon bulges out somewhere else. Regulators are always bound by the “letter of the law” so even if they say “I see what you’re doing there” unless there’s a specific prohibition they can point to, private enterprises will just run laps around the regulator. Compensation restrictions are the triumph of hope over experience (really, they’re just trying to claim to be doing something in the face of AIG-outrage.)

    I have an old adage–never trust a lawyer with the numbers. Lawyers are mostly lawyers because they didn’t like math. Yes, Jodi, if we’re going to have a czar, it should be an economist.

  • 7 S.Ping // Jun 26, 2009 at 4:36 pm

    I feel like large bonuses are not necessarily there to prevent “flight of talents” from an organization. I feel like large compensations exist to make the rest of the food chain slog and slog in the hopes of “getting there,” thereby making the rest of the company more productive. However, I’m not sure if this is an equilibrium. Once the lower rungs figured out that they are just not going to get there, they would probably stop buying in to the idea that if they work hard (or play enough politics), they too will become CEO. As seen in self-help books that seem to be so popular their authors write for Yahoo! Finance, the work force seem to be moving from the 1980s mindset of “work hard in a company, get rewarded” to “chuck work. be your own boss, earn passive income.” This explains why total nitwits like Paris Hilton are so popular these days. She appeals to the crowd of people who likes to think that there are easier ways of making money while being your(nitwitty)self, as oppose to donning a tie and suit and being someone else from 9-5.
    In the end, I think that the market will correct itself, but information just does not flow as quickly as a frictionless world. So in the meantime, there will still be those who aspire to be CEOs, not knowing the amount of people they have to stab in the back and the costs associated with being that person and finding out later that they just can’t get there.

  • 8 Kevin Bjorke // Jun 28, 2009 at 6:45 pm

    Just a SAT Verbal note.

    If socialism == bad, then “czar” is good. “Commissar”… not so much

  • 9 econgirl // Jun 28, 2009 at 7:00 pm

    Update: The Daily Show has something to say on executive compensation (about 2/3 of the way through):

    http://www.thedailyshow.com/video/index.jhtml?videoId=230090&title=f#@ked-or-fixed-economic-crisis

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