Banking Pay: Moan On, You Crazy Downers

The FT continues the investment banking pay debate (it's January: must grumble 'bout dem bankers), granting column space to professor Raghuram Rajan. The impeccable Yves Smith at Naked Capitalism runs the rule over the tone of this article - his her succinct summary of Rajan's point is as follows:

The big issue is that owners of capital (think shareholders investment bank stocks as well as investors in funds) should pay a premium for alpha, or manager skill, and not beta, or market returns. But a lot of people are paid for what Rajan calls "fake alpha," which is basically taking undue but hidden risk, or finding chumps (which can lead down the road to litigation, another hidden risk) rather than creating value for investors.

But what Rajan misses is that everyone in these firms is conspiring together to create the impression that they are all generating real, risk adjusted, excess return. Think I am making this up? I know plenty of people who complain bitterly that they are underpaid when they are making well over a million dollars a year. And none of them could go off and start a boutique business in the same field and generate the same level of income.

Can't dispute this last point. Yet most complainants are only unhappy on a relative basis, remaining secretly staggered with absolute levels of pay (though perhaps not this year in, shall we say, certain divisions). I would like to note in passing that "taking hidden risk or finding chumps" is an impressively precise description of how today's trading floors work either in banks or hedge funds. But one might as well howl at the moon as clamour for changes in compensation structures.

jck at aleablog sides with Rajan highlighting this comment in the original article:

All these strategies essentially earn the manager a premium in normal times for taking on beta risk that materialises only infrequently. These premiums are not alpha, since they are wiped out when the risk materialises.

Yup, agreed again. But so what? Its not like no-one knows this is going on, and has been for years. What's a poor investor to do? Rajan himself suggests this solution:

Compensation structures that reward managers annually for profits, but do not claw these rewards back when losses materialise, encourage the creation of fake alpha. Significant portions of compensation should be held in escrow to be paid only long after the activities that generated that compensation occur. The managers who blew a big hole in Morgan Stanley’s balance sheet probably earned enormous bonuses in the past – Mr Mack certainly did. If Morgan Stanley managed its compensation correctly those bonuses should be clawed back and should be enough to pay those who did well this year without increasing the bonus pool

How clever. How noble! Er no. Preposterous, actually. When I finally clambered back into my chair I re-read it just to make sure he wasn't joking. A significant reason why the brightest still clamour to sign up at these banks, and why investment bank traders desire to run hedge funds is precisely because their pay is a non-recourse strip of yearly call options on market beta and talent alpha. Come on, we all know this, surely. The unwritten rule is that this cliquet option can be abruptly terminated; then you are on your own.

Not that this will seem either fair or reasonable to the common man - the absolute figures involved are extraordinary - but the structure exists because it works. Executive management pay is another issue, but to muck around with rank and file producer compensation schemes is suicide.

Management know this, even if they do fiddle around with the percentage of bonus paid in restricted stock from time to time. The industry is somewhat oligopolistic in this regard - if one firm broke ranks on compensation structures as Rajan suggests, its employees will vapourise, starting with the best, and the firm will be destroyed. And good luck recruiting at Harvard or INSEAD next year too. The real compensation lever available to management is headcount. Timing is difficult, as those who cut the deepest in 2001/2002 found out in the following years, but headcount management works.

Understandably, shareholders (or hedge fund investors) are unhappy when the hidden risks being taken with their capital don't pay off. But let's not fool ourselves that these investors thought they owned a utility. Some of the main reasons financial conglomerates exist are purportedly to smooth earnings volatility and to facilitate appropriate capital allocation. It's not working, plainly. Why not let the market do the job - perhaps what's really needed is separation of capital and identification of risks. Spin the conglomerates into separate companies: Trading, Corporate Advisory, Retail Advisory and Fund Management. The 1970s all over again.

We already know how to value the Blackrocks of the world, and firms that earn fees through the provision of advice. Investors in the Trading entities would demand more by way of competent risk management and disclosure - it;s already happening for hedge funds. These companies would then find their own valuations, in the prior knowledge that investors have already sold a strip of compensation calls to 'dem heinous traders.

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