Banker Compensation, Risk and Reward edition.

Tyler Cowen:

It’s entirely fair to argue that these tests are not decisive. But still, the evidence isn’t there — at least not yet — that executive pay was in fact the big problem…Please leave your reading suggestions in the comments here. So far no one in the previous set of comments has come up with anything statistical, not even weak evidence. Nada. Please don’t let the world violate Cowen’s 2nd Law, which promises: “There’s a literature on everything.”

I’m on vacation in DC – so this will be brief. I’ll take the question at hand to be a more general “does the current compensation structure lead to agents taking higher risk” than the specifics of Fall 2008. First question: executive pay by managers or CEOs? It makes a difference; the arguments I’ve heard is that the managers (or traders) are the liability with the risk/reward difference. Conventional wisdom I’ve heard is that nobody is more dangerous to a hedge fund than a first year trader with little-to-no equity in the operation. After a few years they become safer, not just because of experience but because their nest egg is shared in the total earnings.

Second and main point: Don’t trust any aggregate data produced by hedge funds. They aren’t required to report performance data to a central agency, the data isn’t audited formally, and the survivorship bias and selection bias in the data that is reported makes studying this question impossible.

But mutual funds are regulated formally. And their ability to give compensation rewards based on high-risk is muted due to a requirement in mutual fund regulation to charge along these lines a “fulcrum fee.” So in practice, if we find a result in mutual funds along the compensation/risk lines, it is probably much larger in hedge funds and in less regulated areas. Also there’s a lot of heterogeneity in mutual funds; good luck trying to find a hedge fund or a bank CEO where they don’t give out the risk/reward structure same as everyone else to get a control group. And the mutual fund literature, especially in the 1990s, was really intense – lots of good stuff there. So that’s the place to look.

I used to be into the mutual fund literature years ago, back when it was punk rock; I sadly haven’t kept up as well as I should have. I think this paper is representative, August 2003 Journal of Finance, Incentive Fees and Mutual Funds:


(ungated pdf here, not sure if latest.) More risk, and importantly more risk after poor performance. Their data source seems solid from the paper; I’ll check out this paper in detail, and more of the mutual fund literature, later, but that is the obvious place to start for these questions.

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3 Responses to Banker Compensation, Risk and Reward edition.

  1. financeguy says:

    I think you hit the nail on the head with your observation that it’s the young traders, trying to make a name and score a big bonus, who are the really dangerous ones. They have very little invested in the operation on any level — in fact, some of these guys sort of see themselves as hired guns, parking their boots on some other guy’s floor for a few years cuz he’s providing the capital they need to play with. If Tyler doesn’t see this as an issue, he’s very very wrong, I think.

    But: overall I think the pay constraints movement is a bit of red herring. There are more important things that we need to do. I have trouble even imagining how we go about setting pay/bonus standards for an entire industry. Yes, I think the bonuses are obscene and align poorly with long-term incentives. But I’d rather see the gov training their firepower right now on fixing deep-seated regulatory problems and flushing these derivative trades out in the open and getting control over shadow banking.

  2. Chris says:

    I think the pay packages are a symptom of the real problem: corporate governance. These guys don’t even pretend to work for the shareholders. They work for themselves and the shareholders are just the marks who foot the bills.

    We need a financial equivalent of disbarment for breach of fiduciary duty, and it needs to be enforced on corporate managers. Often. If that doesn’t get their attention, try jail time.

    Corporate management won’t be safe until it is boring and stable.

  3. I simply do not understand a corporate environment where people are paid extremely large sums of money to lard the books with leverage, then continue to get paid equally vast sums after the weight of such leverage drags the company off a cliff, requiring the feds step in with a massive bailout to prevent the economy from collapsing.

    In such an environment, there is absolutely no accountability for one’s actions – which has proven very dangerous in companies that are too big to fail.

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