Yesterday the House of Representatives passed the most recent measure aimed at curbing pay of executives and financial professionals.
Keen observers will notice, however, that Wall Street hardly blinked an eye at this measure, in large part because the Street knows it will find a way to pay itself gobs of money no matter what laws are passed. This is one of the reasons that over the long term, pay at financial firms–whether they are investment banks or hedge funds–remains fixed at somewhere around 50% of revenues.
But don’t get too worked up about that. As it turns out, the premise for wanting to curb or reform the way Wall Streeters are paid is incorrect. It’s not really compensation or the incentives that is the problem.
Yes, this runs contrary to the conventional view.
According to the conventional view, the compensation structure at Wall Street firms encouraged bankers to knowlingly take excessive risks. Let’s call this the “compensation theory” of the crash.
So what’s wrong with this theory? It assumes that bankers are smarter than they actually are. The compensation theory requires bankers to have known the they were making risky investments when they bought triple-A rated securities but acted imprudently because the personal rewards were great and the personal losses were small. That’s just not what happened in the years leading up to our crisis.
What really led to our crisis was that so many bankers were wrong. Take Ralph Cioffi, the Bear Stearns money manager who ran the two hedge funds that blew up in the early months of this crisis. He was just about the most knowledgeable banker in the world when it came to mortgage backed securities, especially one built from subprime mortgages. Bear Stearns originated the very first subprime, CRA securitization. If anyone was in a position to know that he was taking undue risks it would have been Cioffi.
But the evidence indicates the Cioffi didn’t know. He wasn’t engaged in risky investments in pursuit of bonuses. He actually believed that the hedge funds, which were 90% invested in AAA or AA securities, were safe. Even after the subprime meltdown began, his faith didn’t waiver.
Think about that for a moment. The guy in the best position to know about mortgage backed securities was terribly mistaken about the risks involved. No amount of risk-based compensation or post hoc claw back would have prevented Cioffi from engaging in exactly the same kind of investment activities that brought down his funds.
What this means is that even if we change the incentives for bankers–penalising risk-taking somehow–we won’t be much safer. Because we won’t stop them from taking risks they are ignorant about. All the claw-back provisions in the world can’t overcome mistakes based on ignorance. The compensation theory is just a distraction from deeper problems of mistake and ignorance.
So, in a sense, the inevitable failure of reform of Wall Street compensation isn’t really that big of a deal. It was a solution aimed at the wrong problem.
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