The Persistence of Perverse Incentives

There is news today that “regulators are considering whether to require large financial firms to hold onto a chunk of executive pay to discourage the excessive risk-taking that contributed to the financial crisis.” Europe is way out ahead on the issue; “Starting next year, [its] rules limit the amount of certain bonuses that can be paid immediately in cash to 20% of the overall payout, meaning the rest must be a mix of upfront shares and deferred pay.” I would like to be encouraged by the news that the US is seeking to crack down on what can amount to a form of looting. But after reading Richard Freeman’s reflections on the financial crisis, recently published as the Kenneth M. Piper Lecture, it is daunting to consider just how much of an uphill battle pay reformers face:

For the most part, as Harvard’s Rakesh Kurana and Andy Zelleke have stated, during the 1990s–2000s management seemed to operate corporations “for the purpose of creating vast wealth for senior executives.” Just as Bernard Madoff knew he was running a Ponzi scheme, the big Wall Street firms knew what they were doing when they packaged sub-prime mortgages and earned their fees by selling them quickly to others; as one portfolio manager put it, “a lot of people knew this was bogus, but the money was too good.” . . .

As criminal investigators, business reporters, and economic historians probe the behavior behind the financial implosion, I anticipate that they will find less incompetence or ignorance of what banks were doing with their shadow operations and more conscious venality, chicanery, and financial crime motivated by the chance to make huge sums of money.

Freeman is the Herbert Ascherman Chair in Economics at Harvard University and the Faculty Director of the Labor and Worklife Program at the Harvard Law School. He goes on in the piece to discuss how expertise in employment law could help those drafting new incentive schemes for financial institutions.

I would like to see the degree to which Lynn Stout’s recommendations for “prosocial behavior” and business ethics could inform Freeman’s framework. Stout acknowledges that “corporate bad behavior often pays,” but also believes that “trust, ethics, and other forms of prosocial behavior in business are statistically correlated with higher investment levels and greater economic growth.” But it strikes me that high level employees at financial institutions are not motivated to preserve the long-term health of their employers. Perhaps new deferred pay rules could help, but getting 20% of, say, $100 million now via ultra-high risk may be more desirable for an already rich trader than a middlingly risky strategy that generates a three or four million dollar payday. Karen Ho’s book Liquidated suggests that nearly everyone she met on Wall Street worked on an extremely short time horizon. Freeman notes the persistence of the “I’ll be gone—you’ll be gone” mentality in the industry:

In 2008, even the banks that received TARP government aid gave out huge bonuses. Given the precarious state of the financial markets and the public outrage at the banking sector, this behavior has the flavor of “endgame bargaining” in which agents grab what they can as they go out of the door, fearful that there is no tomorrow.

I would like to believe that Freeman’s and Stout’s ideas for reform could be implemented and change the environment. But as conscientious regulators increasingly get ignored, punished, or defunded, I have little faith that matters will improve in 2011.

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