Monday, May 3, 2010

It’s The Compensation Stupid!

(Rather than regulate the banks, get them to regulate themselves)

The recent debate on financial regulation is missing the point. The focus has been exclusively on regulating the financial institutions. This is akin to preventing drunk driving by giving a breath test to the car.

The key problem in the financial industry is not the institutions, it is the people. The people in the financial industry are mercenaries. They owe no allegiance to their employer, to their shareholders, to their clients or to their peers. They are in it for themselves. The problem they work on, every hour of every day, is how to maximize their personal financial reward.

I learned very early in my business career that the most important factor in managing a sales force is defining the comp plan. Salesmen are smart. They will quickly understand what the comp plan tells them to do and they will do it. You had better make sure that the comp plan tells them to do exactly what you want them to do! Bankers are super salesmen. Bankers are smart. Bankers do exactly what their comp plan tells them to do.

What does a Bankers comp plan tell him to do?

First, understand that bankers are playing with Other People’s Money (OPM). What if they lose it all? Well, it’s not their money. What if they invest it conservatively and make a modest return? They probably get to buy a midsize American car and a 2 bedroom house in a distant suburb. What if they gamble it on really high risk bets and they win? They buy a Bentley and a penthouse condo with a 360 degree view. Understand that, when bankers are playing with the OPM, the comp plan tells them to take huge risks. Heads I win, tails you lose! If I lose all your money I will just play again with someone else’s. There seems to be no end to the people who will line up for the privilege. If I soil one corporate platform I will just jump to another.

Many years ago, when the investment banks were partnerships - they played with their own money. The risk management responsibility was understood by everyone in the firm. It was THEIR money!! Then a really smart generation of managers figured out that they could sell the shares of the bank to investors. This was a blinding insight!!

Step 1: get an ENORMOUS windfall by taking the proceeds of the IPO and putting it in your pocket.

Step 2: pay yourself the same amount of money you did when you were the owner. Most of that money should now go to the shareholder but you can always tell them that if they don’t pay it to you, you will quit and go next door and their shares will be worthless.

Step 3: take the shareholders (and the clients) money and gamble it with the objective of maximizing return with no concern for risk. Keep doing this until you are obscenely wealthy.

Step 4: keep inventing new ways to gamble the money so that the game is too complex and moving too fast for the outsiders to keep up.

Step 5: pocket the proceeds along the way. It is very important that you don’t drink your own cool-aid (some bankers forgot this?!)

Step 6: when everything crashes lie low for a while (with your pile of cash) and then emerge with a new hedge fund or another bank and go back to Step 2 (unfortunately Step 1 was a one- time deal - those guys were really smart!).

The amount of money that leaked out of the system into the pockets of the bankers during the run-up to the recent financial crisis was absolutely staggering. The small team that invented the Credit Default Swap at AIG paid themselves over $3B in bonuses before the roof fell in. The AIG shareholders were wiped out. The US government had to put in $100B to keep the company from collapsing. The perpetrators are sailing the Mediterranean in their yachts waiting for the storm to blow over so they can start somewhere else and do it again.

So now our congress is going to create new financial regulations to keep this from happening again. How are they going to do this? They are going to let the big banks fail!!!! WHO CARES!! Maybe the shareholders but certainly not the bankers! If you want to prevent another financial crisis you have to eliminate the reward that the bankers get for creating that crisis! You have to create the right comp plan!

In concept, the right comp plan is simple. You have to keep the bankers from making money if they are doing something that doesn’t serve the interests of the shareholders and the clients. In practice it may be trickier. The key however lies with two principles: fiduciary duty and clawbacks!

Fiduciary Duty – Make it a key legal obligation for EVERYONE involved in a transaction to have a fiduciary duty to their client. Make it incumbent on them to represent to the client that they have done their homework, they have disclosed everything and that they believe this to be a good transaction for the client.

Clawbacks – Create a system where if the banker (the person not the institution) does not responsibly discharge his fiduciary duty then any and all compensation earned on that and all related transactions will be forfeited. You might even want to put some or all of the compensation into escrow for a while (a few years) to make enforcement easier and the message clearer.

Such a system may be difficult to design and administer but the principles should not be hard to embed in legislation. Leave it up to the legal system to administer. Or perhaps there should be a civil agency which uses this structure, sort of like the RICO act, to go after some of the worst actors and make an example out of them. Or maybe a new breed of bounty hunters (ambulance-chasing lawyers no doubt) could emerge to assure the enforcement of these principles.

If every banker had to worry, every day, that there is someone out there who will hunt him down and take the money back if he doesn’t do the right thing, the need for complicated regulation would fade into the woodwork.

It’s the compensation stupid!