What if Wall Street cut everybody's pay by 50%?

The blogosphere blazes with criticism of outrageous Wall Street pay packages, and the White House has joined in on the Sunday talk shows according to this WaPo report.  So here's my question:  What would become of the money if it were not paid out in bonuses?  Wouldn't it all go to shareholders as dividends or retained earnings? 

When the big investment banks went public about 10 years ago, the partners were able to cash out a lot of their capital and henceforth play with other people's money--heads they win, tails the shareholders lose.  They did not, apparently, change their compensation practices substantially.  Shareholders were compensated a little better than debt holders and as well as the shareholders of other financial institutions, but almost all of the great gobs of earnings were still available for distribution to management and employees.  The shift of risk and the great increase in the amount of capital that had to be put to work seems to have contributed greatly to Wall Street's diving into trading and investment practices that caused the recent crash.  Certainly strong regulation of the financial industry to prevent those harmful practices is required, and such regulations might well make Wall Street firms less profitable and, therefore, reduce compensation.  I'd have no problem with that, but simply to require compensation reductions without changing the business models would seem to benefit nobody but the shareholders. Why is populist rage aligning itself with shareholder rights? 

I've written about this before, and I think the danger is that some loophole-laden law nominally limiting executive pay and doing nothing to fix dangerous business models and agency problems will get passed and thereby dissipate the political pressure to act. 

Update on Sunday, October 25, 2009 at 09:00AM by Skeptic

Gretchen Morgenson also sees executive pay as a sideshow distracting--perhaps intentionally--from what government should be doing to protect the financial system from future meltdowns.

For all the apparent action in Washington, some acute observers say that it was much ado about little. Last week’s moves, they say, were tinkering around the edges and did nothing to prevent another disaster like the one that unfolded a year ago.

The white-hot focus on pay, for example, looks like a way for the government to reassure an angry public that they are making genuine changes. But compensation is a trifling matter compared to, say, true reform of derivatives trading.

“The American public understands the immorality of paying people huge bonuses for failures that damaged the economy,” said Michael Greenberger, a law professor at the University of Maryland and a former commodities regulator. “What they don’t understand is that those payments are only a small fraction of the irregularities that took place and that, in essence, the compensation problems, as bad as they are, are a sideshow to the casino-like nature of the economy as it existed, pre-Lehman Brothers, and as it exists today.”

Update on Friday, October 30, 2009 at 09:49AM by Skeptic

Floyd Norris says To Rein in Pay, Rein in Wall Street.  His column includes a graph showing how financial industry profits, which had hovered around 1% of GDP from 1930 to 1980, then grew rapidly to 3% in 2005.  He describes some of the practices that increased profits without commensurate economic benefit in allocating capital to productive uses, and suggests Congress should focus on these causes of the mess instead of addressing the effect of outlandish compensation.  Of course, I agree.

Update on Friday, October 30, 2009 at 10:01AM by Skeptic

The Washington Post has started a Next Great Pundit contest. My entry, which follows, was not one of the ten finalists from the 4800 entries. (BTW, this post was made non-public while my pundit entry was being considered.)

What if Wall Street cut pay 50%? 

Outrage about Wall Street pay packages is rampant.  Hardly anybody thinks any trader or executive is “worth” $100 million for gambling with other people’s money.  However, directly regulating compensation in healthy, non-TARP banks would be a misdirection of our anger and could make things worse. 

If compensation were reduced, the difference would presumably go to shareholders as dividends or retained earnings and/or as avoided dilution of equity.  That would benefit undeserving shareholders and do nothing to change the reckless Wall Street behavior that led to the recent financial collapse. 

What could save financial institutions from themselves, and us from them, is prudential regulation to prevent them from taking unreasonable risks.  Tinkering with compensation and other financial incentives, even including compensation claw-backs, is no substitute for regulation.  Every firm inevitably takes the same risks its competitors take, and they will advance together again onto dangerous ground if they are not legally barred and actively policed.  

When the big investment banks went public in the 1980s and 1990s, the partners were able to cash out a lot of their capital and henceforth play with other people's money--heads they win, tails the shareholders lose.  The shift of risk to public shareholders and the increase in the amount of available capital may be factors that eventually caused the recent financial collapse.  Pay practices may have changed too, but mainly paydays got bigger because profits skyrocketed.  Strong new prudential regulations for the financial industry might well reduce firms’ profits and compensation, but to impose pay reductions without changing the reckless business practices could do the same and benefit nobody but possibly the shareholders. 

Focusing the politics on outrageous pay would likely divert support away from useful legislation and into some loophole-riddled new law that nominally limits executive pay but lets dangerous business models and destructive behavioral incentives continue.  That’s what happened in 1993 when popular outrage led to adoption of a change that disallowed tax deductions for top executive compensation in excess of $1 million per year unless “performance-based.”  This led directly to abuses of stock options and bonus plans, which made things worse for shareholders.  And executive pay went up.  Is it too cynical to suppose there are those who would like to see this head fake work again? 

Update on Friday, October 30, 2009 at 10:06AM by Skeptic

Richard Posner says the world would be better place if financial industry pay packages were smaller, but they should not be regulated, and he has no stomach for regulating industry practices either. 

So I think regulating financial compensation is a mistake. At the same time I think financial executives probably are overpaid from a social perspective. The reason is that their high incomes are generated mainly by speculative trading of stocks and bonds and other financial assets. Speculative profits are not net additions to economic welfare, because they are offset by the losses of the speculators on the other side of successful speculators' trades. That is not to say that speculation has no social value. It generates great social value by bringing about improved matching of prices to values, which encourages investment in productive activities. But the amount of profit that a speculator makes is not the measure of the social value of a successfl speculation. The increase in social value is probably only a small fraction of the speculator's profits.

. . . .

Recipients of Harvard Ph.D.'s in physics are said to have two career tracks open to them: academia and Wall Street. No doubt many are attracted to Wall Street by the much higher incomes they can expect there. Yet their social value might well be greater in academia.

Higher marginal income-tax rates, or a stiff tax on financial transactions, might go a slight distance toward correcting the financial brain drain, but probably it is a problem that we shall just have to live with.

Update on Friday, October 30, 2009 at 10:18AM by Skeptic

This long NYT editorial takes a more nuanced position.  It endorses the Fed's initiative to have banks modify pay practices so that actors are not incentivized to do bad things and are subject to lock-ups and claw-backs if the effects of their actions turn out to be illusory or harmful in the longer term. But, the editorial says, "We still worry about leaving all of these critical details up to the banks — even with a promise from the Fed to be more vigilant."

The editorial goes on to argue for stronger regulation of derivatives than is being proposed in Congress and for a robust consumer financial product protection agency, both of which would reduce financial industry profits and, presumably, pay.