Compensation models on Wall Street

Interesting discussion tonight in my financial crisis class on compensation systems on Wall Street, and the misalignment of incentives short term and long term.

The fundamental misalignment of interests in compensation in the financial firms is that a two fold misalignment:

First, the players think of themselves as free agents, and their annual bonuses as performance-based awards for how well they did that year. But although they think of their bonuses as performance based, the fact that it is based around performance in a single year means that it does not reflect the true economic performance of their work. We won’t actually know that for some time to come, as the bets made that year pay off or not down the road.

Second, therefore, the compensation paid to the players is not really performance based, as though to free agent independent contractors being paid for their performance. It is compensation for labor, even if highly skilled labor, but not different in principle from that of other employees. How do we conclude this? Because although the actual performance of the trades, bets, and other actions will not be known for years to come, the players have been compensated now, this year - and there is no clawback arrangement in case it turns out that it all goes bad. That’s how an employee paid for his or her labor is treated - yes, there is a performance component, but if performance of an employee is poor, he or she is terminated now, no one demands that he or she return the past five years of salary. That is one misalignment - players think of themselves as compensated as free agents but in fact the timing indicates they are compensated as employees.

The second misalignment is that players are compensated in timing as employees - they are paid now and there is no clawback for bad bets. But while the timing of compensation is as for employees, the amount is as though they were equity participants, taking risks themselves and not merely as agents for the firm. The players get the best of both worlds - timing as mere employees selling their labor but amount as though they had their own money at risk, when in fact they don’t. (The fact that poor performance means getting fired or no bonus this year isn’t different in principle from other employees - to make it different, you’d have to claw back past pay because it didn’t pay off.) But the best of both worlds is bad on a welfare basis and bad for the firms, if the firms ever have to worry about the bets paying off beyond the relevant compensation year.