How should bankers be paid? If you’re returning to this blog you’ll know that I’ve written about this before at some length. But this time I don’t mean how much – but with what? It’s a question that often gets glossed over.
In the old days (1990s, when my career started up) there was simply no debate. You got cash, usually just before Christmas and just in time to get the shopping done. My wife’s birthday is Christmas day; I was always grateful for the cash injection.
Later in that decade the idea of being paid in stock began to make an appearance. Typically it would be a fraction of the total bonus and held back for a year or two. So unpopular was this policy when it was first introduced at Bankers Trust that management had to add sweeteners to the deal: a put option on the shares at 80% of the price at the time of the award and – remarkably – a payment each quarter of the greater of earnings per share and the declared dividend. The glum faces on the trading floor got a little more cheerful when the derivative pricing engines were powered up and people worked out that the extra optionality was worth 25-30% of face. (These days there is often a bit of a discount at some banks – naming no names, naturally).
The stated goal of paying in equity was to ‘align the employees with the shareholders’ and it is true that holding a chunk of stock for one to three years did make all of us much more aware of where it was trading. But in reality banks’ motives were less noble. Paying in shares that weren’t delivered immediately (did not ‘vest’ in the jargon) had the effect of tying employees to their employer. Any rival firm looking to poach someone would need to pay off the accumulated chunk of stock. For senior people this could add up to serious money since the proportion of stock typically increased with overall pay. Some got to be like Premiership transfer fees.
But even taken at face value, I’m not sure that the idea of ‘alignment with the shareholders’ really worked. First off, the link between what you were doing as a trader on the long dated swaps desk, say, and the price of the share was incredibly tenuous. You could be making money and others could be losing it. Actions of senior management could have much more impact: buying other firms; selling business units; issuing or buying back stock. Besides, the shares would generally move up and down with the stock market as a whole: every bank stock I’ve ever owned – usually unwillingly – has had a beta significantly in excess of 1.0. Forcing employees to be leveraged long S&P may or may not be a good idea, but whether it results in better risk taking is debatable.
And it certainly is debatable for CEOs and board members. If they are paid very heavily in equity the natural human temptation will be to try to goose the stock higher. Shares are a call option on the assets of the firm. And rational holders of options crave volatility. But stockholders are not the only stakeholders in the firm. There are debt holders too. And, if we are being realistic, the State (thus, the taxpayer) is effectively the ultimate backstop guarantor of most systemically important firms. The more risk is taken with the stock (say with leverage), the more likely is this backstop to be needed.
As my good friend and ex-colleague Jason put it to me: ‘why not align the CEO with the overall capital structure of the bank? Give them debt and equity and see how leveraged they want to make the bank then!’
Back on the trading floor there should be similar questions. Traders and salespeople always get paid the same mix of assets regardless of the product they trade. This is cash and equity in the main, although some banks – CS for example – have reportedly experimented with handing over baskets of structured assets. This means that the durations of the payments are the same. So too are the clawback provisions.
But should that really be the case? Should a trader who trades a cash product (cash equities, say or spot FX, where P/L is reflected in actual cash hitting the bank’s balance sheet in two days) have to wait as long for his or her bonus to cash out as a trader of 10-20 year structured derivatives that are marked to model? Wouldn’t it make more sense to vary the duration of incentive payment according to the weighted duration of the product that the banker trades or sells? To paraphrase my friend: ‘give people bonuses that reflect the duration of the risk they are taking and see how many long-dated deals they want to strap on’.
Clearly, the details of how this might be done are potentially tricky. It would be overly complex to precisely match the duration of each and every employee. But three or four different ‘buckets’ of duration could be done relatively easily – especially since most banks have different payment schemes for different levels of seniority already.
Now I might simply be talking my own book as an ex-FX dealer (many years too late to be fair) whose P/L showed up in cash, but it seems to me that if banks are serious about using the mix of assets in pay to incentivize the behaviour that they want, ignoring the duration of risks is missing a trick. At the very least, it is a debate than banks and their shareholder should be having.
That’s me done: now I’m going to hold my breath until someone takes my idea seriously. If – as I suspect will be the case – you see me turn purple, please ring for a doctor.