Greed is Good. Rethinking Wall Street's Incentive System.

lunedì 15 marzo 2010

 

A controversial bonus season has ended on Wall Street, leaving behind general disappointment. Disappointed are the public and policymakers, who continue to be outraged over the sums being paid to the financial community. Disappointed are the employees at bailed out banks and other financial institutions, as many of them were not so excited about their bonuses either.

 

No matter how big their bonus will be, every year most people on Wall Street are likely to remain disappointed. First, after a yearlong wait, expectations about The Number grow high. Second, The Number has to fill a big gap: bonuses are not only meant to reward good performance and retain employees, but to fulfill a need of satisfaction and accomplishment that embraces many aspects of reality behind work, such as social relationships, family life and personal self-esteem. Third, economists have shown that once an individual gets fairly rich (after certain basic needs are met), further economic growth does not seem to make you any happier.

 

Even for bankers, happiness does not necessarily increase with their wealth, but more from the satisfaction that comes from winning the game. They could be paid in apples, as long as they could get more than last year or more than the other guy. The score, not the dollars, is their primary goal.

 

The psyche of bankers and the subject of executive pay have been on the examining table in boardrooms and on newspaper front pages since the start of the worst financial crisis in 70 years. From my standpoint, there is nothing I see that gives me the slightest hope these people have learned anything from the recent crisis. Gordon Gekko’s motto greed is good still matches very well Wall Street’s motivational culture. After all, like my boss was used to say: ”we all love cash”.

 

Greed is good. Gordon Gekko was right. First, making money gives you a clear measurable purpose, and having a purpose makes people happy. Second, being paid is just another way to feel valued and recognized, which also makes people happy. Finally, having lots of money in the Unites States is an efficient way to access many things that generally make people happy: quality healthcare, better education for your children, good food, fine arts, etc. This is simply how a capitalistic system works and it is so much more appealing because it embraces real and rightful needs of every human being. Like my boss said, “we all love…”. Some of us love “cash”.

 

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If you start from the optimistic assumption that the interests and goals of Wall Street’s bankers and executives are not different from the ones of every human being, you could think about innovative ways to motivate them and ultimately change the overall Wall Street’s incentive system.

 

When trying to change an entire industry’s motivational system, there are generally two options: government or private. Government’s remedy is to subject the entire industry to systemic risk regulation, something now being considered by Congress and the administration.

 

However, a regulatory approach does not always work, particularly when you are dealing with extremely capable people. Most of the work on Wall Street is done under pressure to produce results over short time periods in rapidly changing environments while complying with a myriad of rules and regulation. Eventually, these people will figure out how to circumvent whatever new rules you imposed (similarly to what happens if you try to educate your children merely by enforcing rules…). New practices and behaviors will generate unforeseen problems and risks. The problem is that moral hazard remains in the system: great rewards to executives are paid for short-term profits and extreme risk-taking, but the penalties for unsuccessful risk-taking end up being borne by others in the long-term.

 

The alternative (like with children) is to make a different proposition, an offer that is advantageous because it starts from the real desires of the individual, it embraces his freedom and it is effectively implemented relying on the simple principles of participation and accountability. In the business world, this idea is well represented by the concept of partnership.

 

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In the 1970’s, most of the firms on Wall Street were small private partnerships, owned by few partners who paid out a certain share of the firm's profits to non-partner employees while dividing up the rest for themselves. The system provided incentives to create profits (because everyone's performance was continuously evaluated and rewarded or penalized), but also to avoid great risk (because the partners' own money was involved). When the partnerships grow bigger, they went public to gain access to larger funding and to spread out the risks of the business. They tried to maintain a partnership culture and compensation system as best they could, but it was difficult to do so. As a result, we have seen a significant erosion of the partnership model, culminating in the too big too fail situation, where the principles of participation and accountability have been completely diluted: you are compensated more if you behave well but if you do wrong, nothing will happen.

 

What is interesting about partnership, participation and accountability, is that they are all direct manifestation of freedom. While the short-term approach starts from the impression of being able to control uncertainty, so that individual freedom can be boxed into a series of rules, the long-term approach embraces uncertainty and recognizes that the solution to systemic risk actually relies in the freedom of the individual and the totality of his desires.

 

Uncertainty in financial markets cannot be removed, instead needs to be embraced. Reforms will not guarantee that we will not have another Wall Street failure. A risk will always remain in the system. Policy makers and regulators looking for effective rules to prevent future crisis should consider the one rule Saint Augustine’s offered for morality: dilige, et quod vis fac - love, and do what you want.

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