Peter Weinberg takes to the op-ed page of the Wall Street Journal today to issue a nostalgia driven call for compensation reform on Wall Street.
Weinberg was a partner at Goldman Sachs during the era when the partners of Goldman decided to abandon the partnership in order to become a publicly held company. Goldman was one of the last of the big Wall Street firms to make this move, although Weinberg curiously avoids discussing why so many of the former partnerships went public.
He does explain, however, how earlier rules had prohibited the move.
Prior to 1970, the New York Stock Exchange had a rule prohibiting brokerage firms from being publicly traded companies. There was a genius to this rule. It aligned the interest of the partners of old Wall Street with that of the securities markets themselves. Today, all the large firms are publicly traded. This has given these firms needed permanent capital, but has also served to distort incentives.
It would be interesting to explore what interests and idea were behind the adoption of the NYSE rule and how that changed. Why did the cartel of financial interests that controlled the NYSE at the time abandon the belief that publicly held corporations needed to be banned? It strikes us as potentially dangerous to attempt to ameliorate alleged side effects of the corporatization of Wall Street without understand what problems and goals this change was aimed at addressing.
Weinberg seems to take it as self-evident that the current compensation model used by most Wall Street firms creates systemic risk. As we have explained again and again, this is far from obvious. Indeed, the weight of evidence is against the compensation theory of our crisis. It seems to have become a favourite theory of regulators and journalists because it seems so simple to fix: we’ll just change the way these guys are paid and then everything will work out great. This is exactly what attracts Weinberg to the theory.
“We can’t snap our fingers and turn public financial institutions back into private partnerships, but we can realign interests by restructuring executive pay,” Weinberg writes.
This strikes us as as good evidence we’ve seen the the ideology of investment banking has survived the financial crisis intact. Stated briefly, that ideology holds that our greatest challenges can be resolved thought the application of intelligent management and the proper aligning of incentives.
Here’s Weinberg’s proposal:
First, institute what is called a “10/20/30/40” plan. Under such a plan, junior employees would receive regular competitive pay, but senior employees would be paid as follows: 10% of annual compensation in cash now; 20% of annual compensation in cash later; 30% of annual compensation in stock now (with a required holding period); and 40% of annual compensation in stock later.
“Now” means paid immediately at the end of a compensation period. “Later” means after a period during which a cycle can be evaluated. During that evaluation, the firm’s compensation committee would perform a “look back” in which it can adjust the award or leave it at a predetermined level. This function should not be used to micromanage past bonuses but simply to make sure success in a specific year was still viewed to be success in hindsight.
Second, create a “Skin in the Game” plan. When an executive or a senior employee manages a trading or asset-management business which can be measured by its own profit and loss statement, those executives or employees should invest a significant amount of their own capital in that business or fund. The compensation committee of the company’s board would determine who qualifies for this plan and the definition of a material commitment.
Would this work? Well, it might. It sure seems to properly align the incentives of bankers with larger social goals of long term stability. But since malignant compensation incentives probably weren’t a primary cause of our crisis, this may just wind up creating a false sense of security. And that misplaced confidence in the stability of the financial crisis would likely bring about a new, worse crisis.
Perhaps more importantly, it’s not really clear that we can avoid addressing what Weinberg assumes must be avoided: the overall governance structure. Compensation is just one part of the governance contract at Wall Street firms. Another part–the conflict between managers with economic fortunes tied to a single firm and diversified shareholders who prefer more risk–remains intact. It’s very possible that the systemic risk created by investment banks is simply inevitable as long as they continue to enjoy access to permanent capital as large, publicly held corporation.
In some sense, the market may have already arrived at this judgment. Over the past couple of decades huge amounts of impermanent capital has flowed into the financial sector in the firm of investments in hedge funds and private equity firms. Interestingly enough, although there were losses at many hedge funds, they survived the greatest crisis in financial history since the 1930s in a state of relative health. The wisdom of impermanent capital funding of financial firms seems to have been borne out.
Of course, regulators were going in precisely the wrong direction prior to the crisis and will likely continue to head in that direction. They worried that unregulated hedge funds were creating systemic risk, while the real problems were growing up inside of regulated banks and insurance companies.
This is a reflection of the governmental counter-part of the ideology of investment banking at work–a regulatory ideology that assumes risk is created by the absence of regulation and can be reduced by its presence. At the very least, we’d have hoped the ideology of regulators would be somewhat diminished by our crisis. Unfortunately, it seems stronger than ever.
What we should be doing is wondering which rules and regulations might stand in the way of further innovation of the governance structure on Wall Street. Instead, it seems we are looking to further lock it in place. While not saying so explicitly, many of our rules seemed design to require large financial firms be publicly held corporations. It’s just the mirror image of the old rule prohibiting the NYSE members from being publicly held.
No one was been more forward looking when it comes to this than law professor Larry Ribstein. As he recently wrote:
The uncorporation is a market approach to deal with the fundamental problems that became evident over the last year or so. That approach involves a different overall governance structure, not just haphazardly shooting at a politically vulnerable target. Nevertheless, plans for new financial regulation suggest the government wants to hobble the uncorporation with costly and unnecessary disclosure rules.
If regulators and legislators really wanted to solve problems in financial markets they would try to figure out what went wrong and take account of potential market solutions. But isn’t it much better from their perspective to regulate in ways that will mess up markets and thereby create more regulatory opportunities later on? Financial regulation as perpetual motion machine.
Hopefully someone out there is listening.
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