Monday, 15 September 2008

Here's one idea

Let’s have a proper debate about pay at the top. I don't mean the Polly Toynbee style combination of moralising and inverse snobbery (which I actually think is counter-productive), let's focus on how top pay really works and what it can and cannot achieve.

There are myths that need to nailed once and for all - like that it is (or even can be) linked to performance. Performance of what? Linking rewards to share price has created incentives for the board to manage one indicator, even if that means encouraging them to delay projects, embark on wasteful M&A activity (PDF) or other counterproductive behaviour, rather than just getting on an running the business. And in any case trying to incentivise certain types of behaviour might overwhelm intrinsic motivation to do the right thing.

There's also the problem of the legitimising effect of excessive remuneration. High executive pay also creates the (false) impression that business success is built upon the actions of a small number of brilliant people in the boardroom. And unfortunately I think the shareholder approval vote (and the fact that so few pay policies are voted down) can actually provide a fig leaf - if 'shareholders' aren't bothered by high pay it can't be a problem.

So if shareholders (by which we really mean fund managers) can't police pay effectively, is it time to think of other ways of dealing with it? So why not explore the ideas suggested right at the end of this paper – what about limiting pay to a set % of either market value or profits? Is a maximum pay differential within companies a bad idea? And why not bar companies from providing differential pension provision to the boardroom and the shopfloor?

12 comments:

Nick Drew said...

we discussed this before; there are several intelligent ways to make bonus payments less structurally counter-productive

as regards financial institutions, I like the idea floated somewhere recently (can't recall where) of making bonus payments an input to capital adequacy calculations, on the entirely rational grounds that the higher the bonuses, the more likely the disfunctional (= risky) behaviour

that'd get shareholders' attention

Nick Drew said...

PS Tom, you still confident this one isn't going to be as bad as the 70's etc ...?

Tom P said...

Hi Nick

Yeah it's looking a bit scary out there now. But to what extent do you think the chaos is extending beyond the financial markets? That's the thing I'm less sure about, since most predictions (and that's all they are obviously) suggest the economy will start moving again relatively quickly.

Nick Drew said...

my thesis, as you probably know, is that the dominos fall more slowly than most folks imagine

building sector has of course already cratered in UK, Ireland, Spain, USA, ...

autos on the brink

I have an insight into the steel sector - a fairly good indicator - and they are seeing it already in orders for some steel products, but not others (e.g. China is still rebuilding 30 - thirty! - cities of pop > 1 million after the earthquake, so plenty of demand there, + many large existing energy-related projects still going ahead)

also I periodically take the pulse of lending into the leading edge of the energy sector. At the last soundings it hadn't been affected but I will feed back when I take my next reading

Tom P said...

yes I was interested by you argument about how long the impact actually takes to be felt.

by the way I was going to ask if you fancy doing a guest post at some point?

Nick Drew said...
This comment has been removed by the author.
Nick Drew said...

a pleasure - what would you like ?

Capitalists like to say *yes*

(I do dreadful doggerel and caricatures too)

Tom P said...

Maybe we could do a short Q&A? I'm interested in you and your fellow capitalists' views on how bad the current situation is, and also what us lefties get wrong when we try and critique capitalism.

Nick Drew said...

OK, fire away - via the comments here, if you like, then you can hoist a post

(or via our email-a-Capitalist address & make it clear it's for me & not the other 2 troublemakers: there may however be a slight delay via that route)

Tom P said...

OK, how about these? (some of them cover territory you & me have been over before but I thought it be useful to put things together) -

How bad do you think the current crisis is?

Is it confined to the financial markets or is affecting the 'real' economy?

What impact do you think the crisis will have on a) financial regulation b) financial innovation?

Is the private equity boom over or just taking a breather? Was it just debt driven?

Quite a few serious commentators have said pay in the financial sector has been part of the problem. Is this right, and if so what can be done about it?

Is shorting a problem or not?

Shareholder groups appear noticeable by their absence from the debates about pay, shorting etc. Does it mattrer, and any thoughts on why that might be?

A financial crisis ought to provide opportunities for the Left to advance a critique of free market capitalism. Where do us lefties get it wrong, and do you think we have a role to play?

Nick Drew said...

here we go - it's a bit long, so maybe split it up ?

How bad do you think the current crisis is?

Until recently I would have said much worse than most people think (see my posts for the past 15 months passim) but now I’d say: as bad as can be realistically imagined. Fighting-in-the-streets bad.

As you’ve gathered, I’m not one of those capitalists for whom blind optimism is a moral imperative.

Is it confined to the financial markets or is it affecting the 'real' economy?

Don’t be daft, there’s only one economy. No man is an island …it tolls for thee !

What impact do you think the crisis will have on a) financial regulation b) financial innovation?

I hope that financial regulators will take an unbendingly rigorous interpretation of their existing mandates. Had they done this over the last 10 years we would not be where we are now. It is politicians who set the climate on these things and regulators have been told to lay off. Brown (for example) is highly and personally culpable in this regard - an absolute outrage (I shall be posting on this soon).

Nothing inexplicable has happened. Due to these ‘light-touch’ and non-interventionist interpretations of the mandate, basic risk-management and risk-measurement precepts have not been followed: so financial institutions have been allowed to get away with being grossly under-capitalised. Oldest story in the world. Capital adequacy is the key (followed closely by diversification).

You can’t stop innovation. Like atomic physics, the genie is out of the bottle – people (some people !) understand how to think about finance more clearly than ever before. They will go to their graves thinking the same ideas, wherever and whenever application of them is possible.

Is the private equity boom over or just taking a breather? Was it just debt driven?

PE means many things – the first big PE funds were just divisions of investment banks and we may not be hearing much from them for a while. Some PE’s have done clever, potentially enduring things and will be around to keep playing the game. Others have just pissed their clients’ money up the wall. It was – or became – debt-driven, but then again, so did almost all investment when borrowing was so ridiculously cheap ! Even Sovereign Debt has become accustomed to leverage.

Quite a few serious commentators have said pay in the financial sector has been part of the problem. Is this right, and if so what can be done about it?

Absolutely. Dysfunctional bonus schemes are a cancer. Because so few people bother to learn in detail what’s going on (see your final question), for those who see clearly it’s been like taking candy from a blind child. A couple of horrible similes there, and I meant them that way.

Ideally, shareholders (see below) in their own interests would carefully structure schemes that served the company’s long-term interest – it’s not difficult! As a back-stop, as I said the other day, I like the idea of the comp scheme being an input to capital adequacy calculations – that would get attention, believe me.

Is shorting a problem or not?

Intellectually, no – indeed, in theory it’s a vital mechanism (it was shorting that revealed Enron for the house of cards it had become). However, in (current) practice, it has proved too easy to play market-manipulating games using short strategies – tricks that if done on the long side would be illegal.

Clever players will generally find ways to short things. So it’s best that it is made available to all investors, put on a transparent footing, and manipulative practices clamped down on hard (back to regulation again).

Shareholder groups appear noticeable by their absence from the debates about pay, shorting etc. Does it matter, and any thoughts on why that might be?

Of course it matters: as you have endlessly and correctly pointed out yourself, it undermines what ought to be a key plank in the economic theory of the corporation.

But you can take a horse to water … let’s face it, voters in political systems don’t exactly pull their weight ! - but there should be some structural improvements made. One would be to resolve the conflict of interest where non-execs cheerfully propose crazy comp schemes because back at their own ranch they know they’ll be getting just such a scheme from their own non-execs in turn. Institutional shareholders often have parallel conflicts (as well as useless performance criteria, see Taleb passim).

Lemme tell you that in privately-held companies, shareholders don’t laze around scratching themselves. In public co’s we need the concept of the Hero Activist Institutional Shareholder - a concept that is basically lacking. He’s the one I want managing my pension-fund.

A financial crisis ought to provide opportunities for the Left to advance a critique of free market capitalism. Where do us lefties get it wrong, and do you think we have a role to play?

It should indeed be that opportunity. Lefties are fundamentally disadvantaged because (a) you are all so hooked on big, sluggish World-View ideologies with ethical pretensions (apparently it’s actually virtuous to believe the crap you people catechise so painstakingly), whereas we are empiricists, and nippy with it; (b) the world rumbled this 20 years ago and now everyone ignores you; (c) lots of you (present company excepted !) are idle buggers and some of this stuff needs heavy-duty thinking, hard sums, and hands-on, real-world working experience in finance.

Result: it’s like a bunch of medieval schoolmen trying to understand string theory using Aristotle. Of course no-one listens.

But of course you have a role to play ! Contrarian viewpoints are the stuff of capitalism. Let’s have a bit of compelling anti-thesis - get stuck in, guys !

Closing anecdote: a very dear uncle of mine, a lefty cleric, towards the end of his life said that if he had one regret it was that for 60 years he skipped the financial pages, and only then realised that they are the important ones.

Tom P said...

excellent - cheers Nick!

I think it will be ok in one post.