Economy: Are Wall Street Bankers Paid Too Much?

There is a lot of righteous indignation over Wall Street bonuses. People want to know why the men and women responsible for trillions in economic losses deserve more than $18 billion in bonuses. The very idea that these bankers should get a reward just doesn't compute on America's Main Streets. Why, many wonder, should these villains be commended while those protecting our country in Iraq and Afghanistan get paid so relatively little? And for that matter, don't other heroes like police and firefighters perform at high levels without bonuses?

Let's not be dewy-eyed about this—we don't expect nor should we want heroes on Wall Street. There aren't any. For better or worse, financial incentives are the heart of capitalism and free markets. We have prospered for many decades with arrangements that tie pay to performance. What we should expect and do deserve is that financial managers be honest, skilled and align their interest with those of shareholders. It is not the bonus culture that's to blame. The problem is how executive bonuses are implemented.

Does Wall Street attract more than its fair share of villains? Possibly—as Willie Sutton is reported to have said, he robbed banks "because that's where the money is." Given the amounts at stake, we've come to expect periodic examples of excessive greed. The Thain Gang did no better at Merrill Lynch after Stan O'Neal's widely criticized tenure at the bank. They were all able to do this because Merrill's defenses (the Compensation Committee of the Board) were weak and enforcement was lax.

Heroes and villains aside, it is useful to consider some facts. The problem of executive compensation is a classic principal-agent problem with unobserved information—how do you structure rewards for agents (managers) so that they make decisions that are in the long-term interests of the principals (the shareholders) when the strategies of the former are hardly discernable?

The implications of the theory are fairly transparent and sensible. Lots of research shows that the best way to align interests is to give managers significant stakes in the future value of the company they're running, in the form of restricted stock and option grants. But the problem with the current Wall Street bonus system is that it rewards short-term targets at the cost of jeopardizing long-run objectives.

We have studied the compensation of Wall Street CEOs in the finance, insurance and real-estate sector (FIRE) with the pay packages in other sectors. There are two features that stand out. First, executives in the FIRE sector really do make considerably more than their counterparts in other industries. Secondly, CEOs in the FIRE sector tend to receive a larger part of their compensation as stock (usually restricted stock). In actuality, that structure helps wed executives' interests with those of shareholders.

Problems do, however, emerge when one looks at how companies compute and allocate their bonus pools. Normally, they're divided among participating employees according to how much each contributed to the success of the firm. The intent: to reward good past performance and motivate effort in the future.

But all too often the profits that determine the size of the bonus pool are based on trades that produce short-term returns from taking on more risk. For example, in many firms it was enough to book profits on the short-term difference between the yield on AAA-rated mortgage-related securities and the internal cost of funds. This seemed like free money at the time—until these securities turned out to be extremely toxic. Bonuses were based on assets that were not correctly assessed and on profits that were not real. As it turns out, it isn't really possible to tell what "profits" are except over a longer time horizon.

Attacking bonuses, while appealing, is not helpful. The people who get them may not be heroes, but they aren't villains. Addressing the problems of the compensation system by imposing salary caps, as the new Obama administration has done, is also misguided. The requirement that newly awarded equity grants do not vest before all government money is returned is a step in the right direction. All bonus pools should be based on long-term profits and vested only slowly over time.

But perhaps more important, the administration would be wise to get out of the CEO compensation business. What the federal government should focus on is a revamp of the Securities and Exchange Commission, which needs to do a better job of policing corporate boards and how they handle CEO pay and uphold shareholder interests. With better corporate governance and correctly using Wall Street's bonus traditions, the villains of our economy might one day be heroes.