Monday, May 25, 2009

The Bonus Boondoggle Explained!

Since learning of the massive bonuses earned by the Wall Street execs who drove their firms (and the economy) off a cliff last fall, I've been wondering a lot about what happened to the English language to render a "bonus" something granted to a highly paid executive - no matter what.

I had always thought (and had always experienced) a bonus to be a reward for superior performance. Not, as we've seen this year, something expected in return for running a business into the ground and taking the nation's economy down with it.

So I was thrilled to read an essay by Jon Danielsson and Con Keating on Vox explaining just how the bonus culture took over the financial community.

Once upon a time in finance, according to Danielsson & Keating, bonuses were rewards for success. That changed when the financial partnerships that once were the norm in finance were replaced by limited liability corporations:

"Partnerships have disappeared over time, and the predominant institutional structure in the financial industry is now the limited liability corporation. This transformation is a key reason for the emergence of the bonus culture, because it substantially reduces the incentive of senior management to monitor risk taking."

Traders tend to maximize short-term revenues - and in the partnership era, the potential liability that could be suffered from such a short-term focus provided incentive for senior management to oversee the trades made by junior members - and (hopefully) prevent risky behavior from taking down the firm.

Because of the changes in how the limited liability corporations operate, the incentive for senior management to provide oversight has vanished:

"If there are neither employment penalties nor significant personal costs associated with having run a failed institution, the senior management has incentives to adopt high-risk strategies for profit, since failure does not mean high personal costs."

Danielsson and Keating feel that divorcing management from liability clears the way for risky business to take over common sense. In this, they are men after my own heart. Look at what they have to say about the bonuses paid for by the bailout:

"In their haste to ensure the ongoing business of failed institutions and a desire to avoid taking direct ownerships of the financial institutions, the authorities overlooked the issue of onerous (and indeed sometimes odious) contracts that would continue.

The argument that a bank receiving public support needs to retain the services of these traders, with performance of the contract important, is nonsensical. Losing money, even by bad luck, removes any justification for bonus payments."

Danielsson & Keating offer some solutions to the bonus issue:

"Financial institutions should adapt elements of partnership structures to the limited liability financial institutions of today. Senior management (the partners of old) need to have a substantial part of their compensation deferred over a long period of time, with the amount of compensation directly related to the long run fortunes of the firm. Any senior manager in an institution receiving public assistance should lose all of their deferred compensation. By contrast, the supervisors should not mandate deferral of trader bonuses or regulate junior employee compensation. This provides management with an incentive to check for gaming.

The supervisor should have the power and the obligation to impose a lifetime ban from working anywhere within the financial sector, including a nominal unregulated part, for egregious activities. Such powers should be used for managers responsible for financial institutions failing or needing public assistance. For individual traders they should be restricted to breach of limit or risk assessment gaming, especially when bonuses have been retained. This would be a powerful enforcement tool because for most of the trader’s life the future is worth more than the immediate past."

In the end, we have today a financial culture that appears completely removed from suffering any consequences at all for risky behaviors that threaten a firm's survival. Executives at financial firms pushed the boundaries to the limit - reaped astronomical profits in the last few years - and then were scooped up in a federally funded TARP when they crashed last fall.

And they got their bonuses, to boot.

Danielsson & Keating believe that "the bonus culture, created by structural changes within the financial system over the past three decades, was a direct contributing factor to the current financial crisis."

The question remains, however - do we have what it takes to initiate real reform that will prevent such a crisis from happening again?

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