Tuesday, January 12, 2010

Incentive mis-alignment on Wall Street

I see that Barry Ritholtz at Big Picture sees my point about the mis-alignment of incentives on Wall Street, but he hasn't taken the next leap about my suggestion to bring back the partnership investment bank:

I always found it an amazing coincidence that none of the private partnerships got into any trouble. Coincidence? Perhaps not — from page 136, Bailout Nation:

More importantly, banks started adopting the “eat what you kill” compensation systems. The bonus structure, replete with short-term financial incentives, began to dominate banks. Throw in monthly performance fees and annual stock option incentives, and you end up with a skewed business model suddenly embracing quicker trading profits.

“This had an enormous impact upon the ways investment banks approached business generation and risk management. Like many public companies, they became increasingly short-term focused. “Making the quarter,” in Street parlance, meant pulling out all the stops to hit your quarterly profit figures, by any means necessary. Incentives became misaligned with shareholders’ interests, as risky short-term performance was rewarded with huge bonuses. Not surprisingly, this worked to the detriment of long-term sustainability.

But short-termism was only part of the equation. Of greater concern was how these firms’ internal risk management changed. Unlike in public corporations, partners are personally liable for the acts of any of the members of the partnership. If any one of a firm’s partners or employees loses a trillion dollars, every last partner is on the hook for that money.

Putting a supertax on banker bonuses will not solve the problem. The problem is the lack of incentives to pay attention to risk management. Partnership structures will do that.

Has anyone noticed that partnerships, such as lawyers and accoutants, rarely blow up? Even if they did, e.g. Arthur Anderson, they didn't bring down the system?


Ritholtz said...

No objection from me -- I doubt they have the captial to go private, though.

tom brakke said...

Cam, you're on the money (as usual).

A year ago, I did a series on misaligned incentives in the markets. Looking back, it's amazing and sad how little has changed. I don't think we learned much from the crisis.

Davie Lee said...

Completely agree. As a professional who works in Risk Management, I see so many flaws with the current system. Its still hard to control the traders who are so focused on short term profits.