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November 11, 2011

Ban stock-based compensation for bank employees

Back in the '90's, when I worked as the corporate strategist for a leading bank, Derivatives and the "Quants Jocks" were beginning their creation of investments that could be sold over phones, and then the Internet. I worked for the CEO and the top 25 SBU heads. At that time, the CEO said he did not want these fancy instruments because he could not get his head around them which signalled a strong message to me as he was a very numerate man. I respected his push back frommaking a lot of fast money.
He soon came under pressure as the bank began to fall back in the public stock market performance.
Since my boss was CEO but also the founder and still the owner of majority shares, he could refuse to go down the path of paid or employee CEOs who have put the entire world economy in such a terrible state. Hired bank CEOs raced to bring in derivatives because they boosted their results; why would they care about bank performance five years from now as they would probably be gone?
Pay for performance puts pressure on employee CEOs to act in their own self interest, enrich their personal bank account and try to keep up with all the other superstar bank CEOs.
Roger Martin, Dean of the Rotman School of Business in Toronto and a prolific author, has an excellent article on this topic of how bank executives are rewarded and the havoc the past pay structures have played as a result. Here is his comment on Chuck Prince saying Citibank and all the other bank CEOs kept dancing until the music stopped:

The answer was that thanks to the structure of their compensation, major bank CEOs were obsessed with their stock price and trying to keep beating expectations until the music stopped.  And the asset-based derivatives market was their clever device for beating expectations for much longer than could have happened before – because it was the world’s first market of infinite size. And it worked for them.  When the music stopped and expectations came crashing down, they were by and large wildly rich.
Public companies, such as FHFA’s target list, operate in two markets.  In the real market, they produce and sell real services – like mortgages and mutual funds – for real customers – like you or me or your company – who pay them real money, which, in a successful company, results in a real profit at the end of the year. They also play in an expectations market, where investors observe what is happening to the company in the real market and, on the basis of that, form expectations about what will happen in the future. It is the collective expectations of investors that determine the company’s stock price.
While most assume that stock-based compensation is an incentive to improve real performance, it isn’t.  It is an incentive to increase expectations about future performance because an executive’s stock-based compensation will be worth a penny more than when it was awarded only if the executive can cause expectations to rise. So the primary incentive at all times for executives with heavy stock-based compensation is to increase expectations – even when expectations are so high they can never be met.
So how heavily stock-driven were the bank CEOs?  There is very nice data in the study of the compensation and stock sales of the CEOs of the 14 leading American financial institutions by scholars Sanjai Bhagat and Brian Bolton. Seven of the American financial institutions accounting for 94% ($116B) of the FHFA suit totals for the American firms ($123B) are included in their study (Bank of America, Citigroup, Countrywide Financial, Goldman Sachs, JP Morgan Chase, Merrill Lynch and Morgan Stanley).  It shows that over the 2000-2008 period, the CEOs of these seven companies were making small fortunes by exercising options and selling stock – an average of $139M per CEO. That is almost double what they made in cash compensation ($78M apiece). They lost, on average, $83M in the market crash, causing some to argue that they weren’t taking excess risks because they had so much skin in the game. But it is hardly a compelling argument for a group that was left with net proceeds of the 2000-2008 period of $133M each, plus remaining stock holdings of $76M each.  Remaining personal wealth of $209 million is not bad given the massive destruction of value suffered by their shareholders and the American taxpayers.
So why did Chuck Prince feel so compelled to keep dancing? Shareholder expectations for Citigroup performance just kept rising.  During the 1990s, its stock increased 15-fold. Hence, expectations of future performance for Citi rose an incredible 1500%. And they increased another 50% between the beginning of 2000 and May 2007.  Goldman Sachs almost tripled between January 2000 and October 2007.  On the other side of the Atlantic, Barclays quadrupled in the 1990s and then more than doubled between 2000 and February 2007. These were universally sky-high expectations – and their stock-driven CEOs had to keep increasing expectations from the already sky-high expectations or their stock would fall, disappointing their overly optimistic shareholders and taking a chunk out of their wealth.
Because expectations take into account everything that investors now understand, the only way to increase expectations from the current level is to positively surprise investors – to produce results better than they couldn’t have expected.  That is awfully hard to do – especially if you did it last quarter and the quarter before that and the quarter before that.  And the financial services business is hardly like the smartphone business, which is growing so explosively that all players can experience dramatic growth simultaneously.  Consumers need only so many checking accounts, savings accounts, investment services and mortgages.  Companies need only so much credit, issue so much stock, and make so many acquisitions.  None of these are the possible source of repeatedly surprisingly great growth for the entire sector.  A given player can produce expectations-busting results by grabbing share but everybody can’t simultaneously – share change is a zero-sum game.
To keep producing positive expectations surprises, the leading financial firms had to create something unreal – something with no physical limits unlike the number of consumers, or real share certificates of real companies.  Their creation was the wide array of mortgage-based derivative instruments.  There was no limit to how much of it could be produced, sold and traded – trillions of dollars’ worth, in fact. As is chronicled in Goldman’s infamous Abacus transactions, all Goldman had to do is call up a crafty hedge fund and a couple of dumb insurance companies and create a product out of thin air to make some extra bucks while taking zero responsibility for any economic consequences. And since investors were not accustomed to the creation of infinitely large ethereal markets, they would be positively surprised for a while – maybe forever, the most delusional of CEOs might have hoped.
But nothing lasts forever – even an infinitely-sized product market – and boosted by enthusiastic and self-interested bank CEOs, expectations get overly high and then crashed spectacularly back to earth in 2008.  And the world is now dealing with an entirely new task: unwinding an expectations-driven market multiple times the size of the entire global real market. No wonder it ain’t going so great!
There is much discussion of tighter regulation of the banks, now that we’ve found out how damaging bad behavior on their part could be for the economy. One regulatory change would dwarf all of the others in protecting the economy: banning stock-based compensation for bank employees. It is not so much about how much they make but what incentives their compensation structures produce. Bank executives need to be turned back to managing the real market rather than dreaming up ways – and there will always be ways – of manipulating the expectations market and making off like bandits while the economy takes it in the teeth.
Roger Martin is dean of the Rotman School of Management. He is also a professor of Strategic Management at the School. A Canadian from Wallenstein, Ontario, Roger was formerly a director of Monitor Company, a global strategy consulting firm based in Cambridge, Massachusetts. He is the author of "Fixing the Game: Bubbles, Crashes, and What Capitalism Can Learn from the NFL." He serves on the Thomson Reuters board of directors.
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