Wall Street Pay Regulation – How to Create a Win-Win Situation
Much has been written and debated over whether the government should regulate Wall Street bankers and traders’ compensation. The proponents and the detractors each have valid arguments to support their thesis. It is all but certain that some form of government regulation will be in place sooner rather than later.
At the end of the day, the biggest question remains will the regulations work? The government can mandate certain rules to be met but as we all know, rules can be broken or circumvented. So here are my thoughts on how the Fed can help create a WIN-WIN situation:
Wall Street Pay Regulation
1) CREATE A PARTNERSHIP – If the crux of the financial crisis was the outsized risk-taking engendered by what the critics called as the ability to gamble with other people’s money, then the only solution is to turn the traders and bankers (for that matter anyone in a revenue generating function) into partners with the firms they work for, and plow back the bulk of their compensations into the “partnership”.
Once someone is gambling with one’s own money, I think one will weight the risk reward a bit more carefully. And certainly if you and I where in a partnership together, presumably we will create a natural check and balance on each other to make sure we don’t squander each other’s capital away.
2) ALL RULES NEED TO BE UNIFORM – Imposing rules on some and not others will create dissent and give rise to greater problems down the road. I will venture to surmise that some very enterprising individuals will be extremely skilled at circumventing whatever rules you will impose upon them by going to other firms (or spinning off separate legal entities) that aren’t subject to the same regulatory constraints. For example, bailing out others but not Lehman was tantamount to tacitly stating that one firm is more important than another, and the ensuing consequence was a heartrending one.
Reality is that it will also stave off any criticism if there is standardization across the entire industry, not just those with x$ in capital. Pay regulations in its fairest manner ought to be applied uniformly to all financial institutions, if it is to be applied at all.
3) DEFINITION OF RISKY / RISKLESS PROFITS & RETURN ON CAPITAL – Does the Fed hold the view that a trader or a banker who generates $10 of profits with $10 of capital should be paid the same as one who utilized $100 of capital?
Also, what if the $10 profits are deemed risk less vs. risky (however the Fed defines it)? The definition of risk must also then be uniformly configured. The deployment in the size of the capital and hence the Return on Capital should be configured into the policy.
4) HOLDING BOTH BUY SIDE & SELL SIDE EQUALLY CULPABLE – Should there be similar regulations for the buy side firms? What if fund managers buy into risky assets simply because they thought they were hot and think they can flip for a quick profit?
What if these fund managers do not even understand the product, let alone understand the risks, and yet, they are deemed as professionals charging a pretty hefty management fees and profit sharing fees for managing money? To simply blame or regulate just the sell side is not the most optimal solution, for it takes two to tango.
5) CLAWBACKS / GAME OF MUSICAL CHAIRS – Whether claw backs work or not will be a function of whether 1) an individual is held personally liable, and 2) a competitor is willing to buy talents with a blank check and reimburse the claw backs?
At the top of the bull market it is impossible to entice “talents” from a competitor to move unless one is prepared to dole out multi-year blank check guarantees.
Most managers on the Street were simply too willing to use stocks as an acquisition currency, they just match someone’s deferred compensation with their own companies’ stocks. Managers were too willing to write blank checks because it is NOT their money.
So going back full circle, if all bankers, traders and revenue producers are now “partners” of a firm, and every time they hire someone, they are paying out of their own pockets, it will change the mentality on the Street. Unless there are regulations in discouraging the self-perpetuating cycle of buying out talents with other people’s money, this will be ineffective.
Wall Street Pay Regulation Has Happened
Creating a partnership will foster greater trust in building a franchise, and force every participant to rethink how they will run their own businesses with their own money. Partnership culture is the solution and will replace the existing mercenary and short term culture on Wall Street.
Some think that Wall Streeters haven’t suffered during the downturn. Tell that to the loyal 20 year Lehman employee who had several million in Lehman stock that went to zero. Because part of my bonus is in the form of company stock, I do feel much more accountable and passionate about the firm. I pick up the random pieces of trash in the hallway. I make sure unfamiliar clients get the right answers instead of just hanging up on them or saying I don’t know, and I always look out for the reputation of the firm.
Readers, please feel free to share your thoughts on ways to make compensation right and whether you agree with Elaine’s proposal or not. Feel free to ask her about her life on Wall St. as well as her decision to retire early.
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Financial Samurai – “Slicing Through Money’s Mysteries”
Financial Samurai says
Sounds fair Elaine. Today’s downturn was a reminder trees don’t grow to the sky forever!
The government needs to unload their stake now, while there are still a bunch of wildly bullish people. You’re right though… it would be irrational for Citi to go back to the go go days so quickly. However, I think they are back already from what I hear!
Hello Financial Samurai:
I read the very humorous open letter and it is certainly a salient question on the gov’t’s mind. It isn’t right on moral grounds but if the gov’t allows Citi (and everyone else) to do it, what can one do? But I personally don’t think the gov’t will allow it. I am surmizing that the Administration does not want another bomb on its hands, so it is going to set the appropriate time at which Citicorp could repay the gov’t. The gov’t has the right to refuse the payment on the grounds that Citi is still vulnerable to another attack, and every day that the Dow drops 200 points will strengthen the gov’t resolve. And I can guarantee you that the gov’t will come out with the regulations before bonus is set, there are enough angry folks working for the gov’t to ensure that.
Financial Samurai says
Hi Elaine – Thnx for your response. To add on to Genius’ question….. what if Citibank unloads all the government shares to the public right before compensation time this year. Do you feel it’s right that Citigroup can now pay their employees the big bucks again, despite getting billions from the gov’t for the past 10 months? This is one of the key question/assumptions we had in the “Open Letter To Vikram Pandit” post earlier. Thnx!
Hello The Genius:
Fantastic questions! They really address the core of capitalism, so here are my humble opinions:
I am a proponent of capitalism and the free market so therefore I do not believe in massive regulations of any sort, on Wall Street or Main Street, EXCEPT in extenuating circumstances where there are unfair plays involved, or in a crisis where it requires gov’t bailout, so as to prevent future crisis. If someone takes the bailout money from the gov’t, which happens to be taxpayers’ money (your money and my money), yes, they should be regulated UNTIL such a time when all the bailout monies are returned (and some), then they can do whatever they like with their earnings. If a firm did not take taxpayers’ money, they should not be regulated. At issue is that the general public feels cheated because the gov’t used their tax money to bailout the very same firms that in turn halved their 401Ks!
I am not here to judge what is too much for someone to earn in any industry, it is supply and demand, and luck (if one is lucky enough to enter a certain high-paying industry), so if someone is willing to write me a $100 Mil check, I will take it (wouldn’t anyone???)!
A BIG “regulated” firm will be able to compete just as well as any unregulated ones since they have enough capital, infrastructure and resources to begin with and will continue to gain revenue, the only difference of course is in pay and one can argue that the best people will go to the unregulated ones. Reality is that every regulation has loopholes and firms will get around the comp issue and make it a pretty even playing field for all. I have seen people get huge guarantees at the top of bull markets only to be told it be be stretched out over 5 years instead of one year when the market collapsed; and I have seen people come in with below market rates and once they prove their worth and have other offers from competitors, the bosses will even double those offers, it is all about timing in this business.
Thanks for your thought provaoking questions.
#2 is a good point. In a free market, any regulations imposed should be to maintain fairness, so if pay regulations are to be imposed on Wall Street then to be fair they must indeed be uniform.
The Genius says
Howdie Elaine – Do you think all Wall St. firms should have their pay regulated, even if a firm received NO tax payer bailout money? If so, what is the “right amount” for someone to make, and does regulation continue to every single industry on earth because people are deemed to earn “too much”?
If not, how do you think firms who are regulated can compete with the unregulated firms? And finally, if a firm does receive tax payer bailout money, but pays it back, should they still be regulated?
Thanks for sharing your thoughts!
Hello Egg Bear:
Many thanks for your comments and support. My personal view is that without gov’t intervention it will get back to and surpass previous highs as long as 1) there is a raging bull market, and 2) there are willing payers who will write blank checks in the names of attracting talents. I have seen record comps broken at every new bull market cycle, and it will perpetuate itself. BUT with populous anger abound and gov’t intervention (which I assume will happen formulaically with some sort of link between risk and rewards/losses), it will put a temporary cap on comp and will lengthen the pay out period. Wall Street comp is feast or famine (or more like smaller feast relative to other industry), if one stays in a cycle long enough, one will see huge cyclical moves in comp, but everyone still make a decent living.
Egg Bear says
Hi Elaine – Thanks for your post and thanks FS for highlighting. Makes sense to align risks with rewards.
I’m curious to know whether you think in general, pay will get back to the go-go days on Wall St. (was that just 2 years ago in 2007?), or whether you think pay will be structurally lower for a long time?