Thursday, September 3, 2009

Bank Executives & The Concept of Risk Reward

Imagine the following scenario: You are an avid supporter of your hometown professional hockey team and over the last several years the general manager initiated a policy of trading away his skilled defensive players in order to produce a team with highly innovative but undisciplined offensive players. Upon enacting this new initiative, the team not only fails to make the playoffs but finishes the season at the bottom of the league standings. As expected the team’s failure was due to a total lack of defense leaving the team vulnerable to any offensive attack from the opposing teams. Furthermore, suppose at the end of the season it became known that while the average player on the team was earning $1.9 million per season, the General Manager was earning a salary of $606 million. Furthermore, imagine if when the season finished the team announced that due to the team’s poor performance that there would be a surcharge on ticket prices that would effective triple the cost to attend a game for years to follow. Would you be outraged? Would you demand that the manager be fired, or at the very least, adjust his compensation to reflect his performance? In all likelihood there would be insurrection and a boycott of the team.

However, this is not how Wall Street works according to the 16th Annual Executive Compensation Survey published September 2nd 2008 by the Washington based Institute for Policy Studies (IPS). In 2008, the year taxpayers rescued the financial industry, chief executives at the top 20 financial recipients of bailout dollars earned 37 percent more than their CEO counterparts elsewhere in the U.S. economy. The pay gap between CEOs and rank-and-file employees has also continued to extend: in 2008, according to the study, top executives averaged 319 times more in pay than the average American worker, compared to 30 to 40 times in the 1980s. CEOs at the 20 top bailout banks earned 436 times more. Is there anything wrong with this picture?

CEO Compensation/Average worker wage.

Libertarians, such as Robert Nozick, appealing to his Wilt Chamberlain analogy, would claim that there is nothing wrong with bankers receiving this level of compensation since it is a rationally achieved outcome as a consequence of the free market mechanism. He would claim that “no end state principle or distributional patterned principle of justice can be continuously realized without continuous interference with people’s lives”—which would be antithetical to his concept of liberty. (Nozick 1974) The problem here is that, shareholders of the bank and ultimately the citizens who bailed them out did not participate in any explicitly rational process in allocating the funds to the executives. The concept of the pursuit of rational self-interst is different than the rationalization of self-love. Nozick's argument that the compensation packages are a result of the free market competitive process to retain skilled talent tends to become farcical when the consequences of their 'skills' are assessed. If these talented gentlemen did this to the global financial system, it boogles the mind to imagine what 'less skilled' talent would have done. It is disheartening to note that morality is not considered a 'skill set' on Wall Street.

Friedrich Hayek, the quintessential proponent of free markets and liberal principles, defends rising social inequality as the opportunity cost of maintaining an efficient market order. However in The Mirage of Social Justice (1982/93) he makes an interesting comment:
It has of course to be admitted that the manner in which the benefits and burdens are apportioned by the market mechanism would in many instances have to be regarded as very unjust if it were the result of a deliberate allocation to particular people. But this is not the case. Those shares are the outcome of a process the effect of which on particular people was neither intended nor foreseen by anyone.

Does the granting of stock options and 'generous' compensation packages qualify as 'deliberate allocations to particular people'? When individuals grant themselves options-- ironically, as an incentive to ensure the growth of the company-- on a stock that they are largely responsible for destroying, it is tantamount to the actions of some backwater stock promoter. Where has the concept of risk reward gone, or does that just apply to the general public. Is this concept not one of the prinicples of free markets? You lose you pay: You win you play...or does this basic tenet not apply to the individuals at the helm of the financial system? You cannot claim that these financial virtuosos dont have chutzpah!

Adam Smith did not have a great deal of respect for managers of joint stock companies, describing to a tee the recent actions of Wall Streets bankers.

The directors of such companies, however, being the managers rather of other people's money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. It is upon this account that joint stock companies for foreign trade have seldom been able to maintain the competition against private adventurers. They have, accordingly, very seldom succeeded without an exclusive privilege, and frequently have not succeeded with one. Without an exclusive privilege they have commonly mismanaged the trade. With an exclusive privilege they have both mismanaged and confined it.

As far as the wages of labour is concerned, Smith tied one’s wages to the amount of trust place in him by other citizens:

We trust our health to the physician: our fortune and sometimes our life and reputation to the lawyer and attorney. Such confidence could not safely be reposed in people of a very mean or low condition. Their reward must be such, therefore, as may give them that rank in the society which so important a trust requires. The long time and the great expense which must be laid out in their education, when combined with this circumstance, necessarily enhance still further the price of their labour.

What happens when that trust is tarnished? Does an individual or individuals who have squandered trillions of depositor’s money still command the trust of the investing public? —especially when they are picking up the bill in the form of a taxpayer bailout, which their great grandchildren could possibly still be paying off.

Clearly, self regulation has proven ineffective in scrutinizing the actions of many of Wall Street’s policies and business models, while at the same time, politicians have proven incompetent and/or reluctant at confronting the abuses of trust perpetrated by companies who have been bailed out by the taxpayer. It is time shareholders of these corporations assert their rights of ownership and demand that some semblance of responsibility and accountability be maintained if executives of failed banks are to continue to reap benefits from a system that they have virtually destroyed. Unfortunately the shareholders of many of the rescued financial institutions are now represented by politicians who are busy hastening the ideological polarization of American society in the venue of healthcare.

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