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Sunday, July 12, 2009

Perverse incentives remain intact on Wall Street

Designing the right incentive system without jeopardizing the whole financial system and losing the talent at the same time remains to be a difficult task. The current revision in comp scheme that pays more in base salary and most in cash seems to have done nothing to change that. The perverse incentives structure is largely intact. Reports WSJ:

Congress wants to lower Wall Street bonuses, blaming them for encouraging the excessive risk-taking that helped cause the financial crisis. But the haphazard way that pay practices are being altered may yet yield the worst of all worlds, higher fixed costs and less accountability, without removing the threat of talent walking out the door.

Banks like Citigroup and Bank of America that still have funding from the Troubled Asset Relief Program are dealing with restrictions on the bonuses they can pay top employees. To keep the rank and file happy, Citigroup is raising base salaries for many of its 300,000 employees who are eligible for a bonus. Morgan Stanley also has increased base pay, from about $300,000 to $400,000 for managing directors. Even stronger performers, such as J.P. Morgan Chase, are considering raising base pay. Credit Suisse is considering all options.

The result: higher fixed costs, even as many banks continue to struggle. When guaranteed salaries rise, so do a range of juicy benefits, as well as severance packages, which are based on salaries. With banks facing increased regulation and higher capital requirements, reducing flexibility on pay could be another blow to investors.

There also is a question of whether higher cash salaries really will mean lower bonuses. The danger is that, even if the likes of Goldman Sachs Group pay out less than half of net revenue in compensation, less-profitable firms might feel forced to pay out a higher portion to keep up. Goldman said it has no plans to adjust the way it pays employees; stars will continue to receive the bulk of pay in bonuses tied to performance.

A perverse outcome of the Wall Street crisis is that compensation as a proportion of revenue could actually rise. Pearl Meyer, of Steven Hall & Partners, estimates that Wall Street pay will end up topping 60% of revenue for the foreseeable future, up from about 50% in past years. It could hit 70% at some smaller financial firms, she said.

To be sure, the "comp ratio" mightn't stay at elevated levels as revenue improves. Morgan Stanley said its payouts looked high in the first quarter because movements in the price of its debt reduced net revenue. Banks said bonuses will be trimmed to keep overall compensation about the same.

Citigroup said its changes were aimed at reducing the focus of employees on short-term results and keeping more of them at the bank for the long haul.

But salaries are paid in cash, while bonuses are usually in cash and shares that vest over time. More cash upfront arguably gives them fewer reasons to stick around or worry about the long-term performance of their firms. At the same time, bonuses aren't going away, so some traders and bankers will continue to embrace risk to try to score the highest payouts. A rise in base pay might help retain middle-performing staff, but it is unlikely to attract or retain the best traders and bankers.

The crisis should lead to a more rational pay structure on Wall Street, with pay remaining flexible and bonuses paid largely in stock that can be clawed back if necessary. Instead, as salaries rise and guaranteed bonuses start to make a comeback, Wall Street firms risk adopting a new set of bad habits.