The Fed has three basic functions: central banking, bank regulation, and calling down police brutality on Occupy Wall Street protesters. While the first function is getting all the attention today, the New York Fed’s blog is spending some time on the second. Specifically, they’re trying to figure out how bankers should get paid.
Optimal design of banker compensation is a thing that people like to think about, and that regulators like to regulate. We’ve talked about it before, and I’ve suggested that the right way to reward bankers is not to give them mostly equity or extra-levered equity, which encourages asymmetric risk-taking, but rather to give them exposure to their firm that roughly matches that of their main stakeholders. Which, for a bank, means basically various flavors of creditors. So a bank CEO whose net worth consists 20% of equity of his firm and 80% of unsecured debt of his firm, like Brian Moynihan, in theory has better incentives to do the right thing by bondholders, depositors and the financial system than someone who’s 100% in out-of-the-money stock options. And a banker who is paid in structured credit products that can’t be foisted on to clients has incentives … well, he’s an interesting case study at least.
I like the NY Fed researcher-bloggers because they’re pretty sober people who want to optimize banking regulation but don’t spend their time freaking out about stupid popular things like how CDS will kill us all, banning short selling, or just generally hating on bankers. So I’m pleased to see NY Fed researcher Hamid Mehran is with me on this whole comp thing:
Because stock- and options-based compensation is unlikely to curb the risk appetites of bank executives, Bolton, Mehran, and Shapiro in a 2010 New York Fed working paper proposed tying remuneration to a bank’s credit default swap spread. An institution’s CDS spread provides a market measure of the risk of a bank. Under our scheme, a high or increasing CDS spread would translate into a lower cash bonus, and vice versa. …
How would this scheme look in practice? CEOs could be required to write a given amount of CDS (or to buy swaps written by other insurers) for the duration of their employment contract. However, a more efficient policy might use money set aside by the bank at the start of the period. Deferred bonuses would then be reduced or increased under a pre-specified formula as the bank’s CDS spread deviated from the average bank spread: bonuses would be increased if the spread was below average and decreased if it was above average.
The paper itself is worth reading. Among other things, it suggests that their CDS-based comp scheme is better than just giving executives unsecured exposure to their banks by paying them in deferred cash comp, for reasons that I don’t really understand. (They seem to assume that banks have to set aside deferred cash in a pot at the time of grant, which, I mean, the whole point is that it’s unsecured, just promise to pay it later and if you don’t have the money tant pis.)
This bothered me a bit, because I am committed to the view that, in efficient markets, debtholders should view widening credit spreads and increasing probability of non-payment-at-maturity as equivalents. Thus the deep magic of DVA, where banks transmute a bad thing (widening own-credit spreads) into a creepy good thing (less chance we’ll have to pay off all these derivatives we wrote!). So, funding aside, a normal creditor of a big bank should be indifferent between writing CDS on that bank and owning that bank’s bonds. But I’m coming around to the Fed’s view, because of course the CEO is not a normal creditor: he got to be the CEO in part by being super optimistic about his bank’s chances. Making him mark his enthusiasm to market is probably a better idea than letting him discount the probability of nonpayment on his own.
Anyway, there seems to be broad agreement among, well, me and some Fed economists and not William Cohan, that giving bank executives a direct stake in the creditworthiness of their levered systemic firms makes more sense than just aligning them with shareholders, because bank shareholders are unsavory risk-loving characters just like bankers are. CDS is a natural proxy for that creditworthiness, and it’s a reasonably objective and liquid market-based proxy.
But there’s also this. Your model of a bank’s stakeholders could be 20% equity / 80% unsecured debt, in which case you could be a big fan of the Fed idea. Or your model could be 2% equity / 8% unsecured / 90% witchcraft and magic. The NY Fed, again, are sober types who are not believers in witchcraft and magic, and most of the time that’s probably a good way to look at the world. But the reason that lots of people like to freak out about bank compensation is that, every once in a great while, the fulcrum stakeholder is not a shareholder or a guy who holds an unsecured thing deliverable into CDS, it’s the financial system as a whole. When 90% of the money at risk in Morgan Stanley was the Fed’s,* Morgan Stanley wasn’t really working for either its shareholders or its bondholders – and its bonds, like its shares, looked like more or less at-the-money options to buy the firm from the vast mass of secured credit (Fed, repo, FDIC-insured, whatever you’ve got at your particular bank) that really owned the place.
CDS obviously reflects this sort of thing – Morgan Stanley CDS didn’t look so hot in September ’08 – but so do stock prices. Both are imperfect, conditional, convexity-laden reflections of the shifting risk profile of banks. Both probably under-reflect the risk to all stakeholders because in a really deep crunch the equity and unsecured are not where the bulk of the capital is at risk. If you wanted to really align bank CEO’s risk-taking incentives, you’d let the Fed empty their personal bank accounts to fund emergency loans to their banks.
Which I’m pretty sure would be a dumb idea. The lesson may just be that you can’t fully optimize comp to make bankers internalize risks. But you can improve from the current baseline. And this CDS-based comp thing seems like a decent attempt.
Designing Executive Compensation to Curb Bank Risk Taking [NY Fed]
* Quoted without approval. I think his math and understanding of how the claims work are iffy but, y’know, the gist is not wrong and he’s not the only one thinking it.
Too early, can't Matt.
[...]
Matt, aren't you supposed to be studying for some big exam?
go back to your room.
Old Mumbles you could probably pay mostly in ball taps. Sure, the proper discounting is tricky, but at a certain level it's not really about the money.
I'd agree, if it weren't for a painfully boring conference call that made reading this article seem worth doing. Still, would it have killed Matt to throw me a chart?
I'm sure my employees/shareholders will vote this bullshit down pronto.
-LB
This article finally gives us a reason to drink coffee!
-UBS IBD
While CDS spreads are a useful tool in accessing risk – they typically over-quantify events, with large news driven expansions and contractions. Lots of reversion.
Plus – just given the new era of mass market volatility, which in part one could argue is driven by the rise of institutional investors like hedge funds (no knock on you) – CDS at times has a tendency to ignore fundamentals.
A rumor might affect the standing of your I-bank when being chosen to underwrite a deal (and miiiight affect the top line, although we still see BAML and MS as major players), but sure as hell will blow the shit out of your CDS. I don't want my comp tied to that.
Interesting Matt…. I mean err Anthony Bologna
B. Moyns looks like he's trying to squeeze an addition to the bonus pool.
Anthony Bologna is a friend a mine.
- cg
I hope I get paid in Trident Layers!
-UBS MD
11:16 you feeling ok Matt?
Excellent tags, Matt!
Too much adderall studying for the CFA…
Matt.
That was a damn good 30-sec elevator pitch on how improve executive comp incentives! Very succint and to the point. We'd like to hire you as a pitchman.
-VC fund
TE,CM?
The IS no more Adderall
– Your local coke dealer
So you stayed up all night typing this instead of studying…you're hired!
-Jeffries HR
god you suck
Matt: I read your posts in their entirety almost every day, partly because I'm waiting for the day when you go off the rails and we discover you're totally full of shit. Hasn't happened yet… but I'll be watching.
-Backhanded compliment guy.
Matt,
Although as typical this is quite the tome, it was actually a decent read on a good topic, and I do sort of wish for once that the responses weren't all jokes. Luck on the test.
I'll preemptively give myself a thumbs down for the comment, I know, I know.
-Not OWS and not a fan of their work, but in favor of finding a way to keep the pitchfork holding masses out of my yard.
What does Conan O'Brien have to do with this?
Such is the schizophrenic nature of the world economic system that US Bank credit ratings are falling while the Dow is on a holiday tear. The system looks good on the outside, but it's hiding a cancer: http://djia.tv/press-tv/top-us-banks-credit-ratin…
Bank of America is a criminal enterprise. How many lawsuits are they in RIGHT NOW? Defrauding investors? Big time! There is a solid reason bank stocks are down. Balance sheets that are contrived nonsense that no one with a lick of sense would believe, massive exposure to UNsecured mortgage securities, and those pesky lawsuits from major investors who now see that those "securitized " mortgages where not secure at all! When BofA admits in their own 10K that they may not have possession of the underlying mortgage notes you know there is massive fraud going on. Please read the 10k s for yourself and see how bad the banks really are. They admit it if you want to read.
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