Leverage and executive compensation

FT quotes Andrew Haldane's work that shows how the increased focus on return on equity (as against return on assets) as the metric for measuring executive performance drove executives into over-leveraging and thereby amplifying risk,

For most of the 20th century the long-run return on equity in UK banking moved in line with the underlying growth rate of the UK economy. Then from 1986 to 2006 the return on equity jumped from 2 per cent to an annual average of 16 per cent. Yet the return on assets was largely stagnant over the period. In effect, the managers of banks took to the roulette wheel. They juiced up rotten returns by shrinking their equity capital and taking on more risk. This pattern was repeated across much of the developed world.

Are superstar cricketers like landlords?

Rajeev makes an interesting observation about India's high-paid superstar cricketers and the role of happenstance and good-luck in contributing to their fortunes,

Since the 1980s, the best cricket players in India have been growing ever richer. However, that they earn a hundred times what their predecessors used to earn doesn't mean that they are a hundred times as good at the game. They have grown richer mainly because Indians now watch television. In some other countries, the benefits have gone to Football players, while in other countries, Basketball players have gained. These beneficiaries may be great athletes, and they "deserve" their incomes in the sense that this is what others willingly pay them in the marketplace. They are like landlords who have seen the value of their properties explode because someone else built a highway or a railway station nearby.

I am in complete agreement on the role of luck in these cricketers fortunes, especially in relation to players from other sport like Hockey. But the analogy with landed rentier-class enjoying the windfall value appreciation from infrastructure and commercial development in the neighbourhood is debatable.

For one, unlike unproductive landlords, these cricketers are talented, hard-working, and productive and deserve to be rewarded. However, even if the market agrees, it is questionable as to whether they "deserve" their current extraodrinary incomes. Critics are right in asking whether their incomes are disproportionate to their abilities and productivity, especially when considered in relation to their peers in other more globally competitive sports.

But this analogy can be extended to many other areas and stands at the heart of the debate about executive compensation itself. Do traders, bankers, and corporate executives "deserve" the fantastic compensation packages they receive? While conceding their abilities and even a substantial premium in their salaries, it is very difficult to justify the size of their remuneration.

Consider this. Two friends, of more or less equal abilities, pass out of engineering college and pursue careers in core engineering and in finance. The former does an MS while his friend does an MBA, both from prestigious universities with equally stiff entry competition. Ten years down the line, the financial specialist earns five (or many) times more than the engineer.

It is too much a stretch to claim that the former has acquired superior skills or is more productive than the latter. The most charitable thing that can be said about his vast riches is that he was lucky to choose the right profession at the right time. And within the profession, he happened to specialize in the right sector and in the right firm. And, we could justly add, in case of financial market executives, that he happened to make the right bets, atleast till date.

Much the same underlying logic can be applied to analyzing the fairness and merits of remuneration in several fields, especially where it is disproportionately higher than the norm in similarly placed occupations. The wage-premium due to good luck is too high to be ignored. In this context, as I have blogged earlier, it may be fair to appropriate some of this disproportionate luck by imposing a higher marginal tax rate on those at the top of the income ladder.

Matt Yglesias too feels that large parts of the economy is becoming more Ricardian with higher resource rents.

Cognitive biases and winner takes all society

Lane Kenworthy has an interesting post where he questions conventional wisdom on the winner-takes-all economy, where a few people at the top of each industry have seen massive increases in their incomes, whereas the take-home paychecks of the rest have remained stagnant.

Supporters of this trend argue that the differential is a well-deserved premium since it is a reward for hardwork and inventiveness. This line of analysis attributes a disproportionately high weight to the good performance of the company (it is another matter that even those with below average performance claim this premium!) to the quality of leadership. Supporters of the skewed financial market compensation in general, and executive compensation, in particular, have argued that the high financial rewards are a reflection of their performance and the innovation that goes along with it.

Since Apple and Steve Jobs are the modern benchmarks for innovation, Prof Kenworthy writes in the context of the discussion on what drove the late Jobs,

"Would Jobs and his teams of engineers, designers, and others at Apple have worked as hard as they did to create these new products and bring them to market in the absence of massive winner-take-all financial incentives... Jobs himself seems to have been driven mainly by a passion for the products, for winning the competitive battle, and perhaps for status among peers. The satisfaction of achieving excellence and of beating one’s opponents appears to have been far more important than monetary compensation. Excellence and victory were their own reward, rather than a means to the end of financial riches... The rise of winner-take-all compensation occurred simultaneously with surges in innovation and productivity in certain fields, but that doesn’t mean it was the cause of those surges."

I agree with Prof Kenworthy and am inclined to the argument that innovation at the highest levels is driven more by passion and desire for peer recognition than by financial rewards. Here are three more observations.

1. The fixation on financial rewards may be an example of availability bias at work. In the mainstream discourse, financial rewards have a deeply entrenched association with achievements and innovations. So there is a natural tendency to subliminally associate any innovation with financial rewards.

2. Further, there is also the strong correlation-causation bias in the winner-take-all interpretation. A successful innovation would naturally result in a flow of financial rewards. So, given the entrenched availability biases about financial rewards causing innovation, the immediate impulse is to attribute the innovation itself to the financial reward.

3. A wage premium is necessary to build up high quality teams that can collaborate in the development of innovative products. However, while intuitively true, this may require more deeper analysis. It would be instructive to examine the great modern day innovations, and assess the relative roles of large team-work and individual genius, in the genesis of the innovation. I suspect that the latter would bear a disproportionate share of the credit for such innnovations. It may be too much of a stretch to argue that Larry Page or Mark Zuckerburg or Niklas Zennström were motivated predominantly by the attractions of a winner-takes-all system and not their inherent personal motivation.

Financial sector and widening inequality

(HT: New York State Comptroller’s Office, via Economix)

Update 1 (15/3/2012)

Times writes,

Before 1990, pay for the chief executives of financial firms were on par with those of chief executives of the largest traded companies, or even slightly lower. By 2005 the pay was roughly 250 percent bigger on average, said Ariell Reshef, a professor of economics at the University of Virginia. Broadly speaking, between 1980 and 2005, bonuses and salaries in finance increased 70 percent more than average pay elsewhere.

Executive Compensation : Business As Usual!

Further confirmation of the fact that executive compensation has little to do with performance comes from a preliminary examination of CEO comempensation figures for 2010 in the US.

A study commissioned by the New York Times show that the median pay for top executives at 200 big companies last year was $10.8 million, which works out to a 23% gain from 2009. The record levels of corporate profits, at the expense of wages and jobs, meant that some of these gains were shared as higher executive compensation.

The median pay raise of 23% for chief executives, while roughly in line with the increase in net corporate profits, far exceeded the median gain in shareholders’ total return, which was 16%, as well as the median gain in revenue, which was 7%. The median American worker's wages were up a mere 0.5% in 2010, and when adjusted for inflation workers were actually making less.



The third graphic is the most instructive. It clearly shows why executive compensation has little to do with performance outcomes. Taking stock returns as a barometer of the companies performance, it shows that executives from similar sized companies with same stock returns showed wide variations in compensation. Similarly, the top executives from health care, oil and gas, and financial sectors showed wide variations in their compensation despite more or less same stock returns. Though stock returns are not the perfect measure of the companies actual performance, the variations in compensation are too large to be rationalized.

Update 1 (8/4/2012)

Times has a nice article on ballooning executive compensation in the US. In particular, it draws attention to Apple CEO Tim Cook's eye-popping $376.2 million stock-options award (to be redeemed over 10 years) in addition to salary of roughly $900,000 in 2011. The options are now valued at roughly $634 million.

The median chief executive in this group took home $14.4 million — compared with the average annual American salary of $45,230. In all, the combined compensation of these 100 C.E.O.s totaled $2.1 billion, the rough equivalent of the estimated annual economic output of Sierra Leone. 

Hedging away stock option risks

One of the important strands of executive compensation reform in the aftermath of the sub-prime crisis was to shift more compensation into long-maturity stock options. This was intended to align employees’ interests more closely with those of investors and discourage excessive risk-taking. It was hoped that this would expose them to the long-term risk of that investment, which would incentivize them to work towards the longer-term health of the firm.

It now emerges that executives have been getting around this issue by hedging their downside on their holdings using complex investment transactions. Hedges allow employees to limit losses, raise cash, or diversify their portfolios without selling the underlying holdings. And no surprises for guessing who is leading the way - executives from Goldman Sachs (sample the Collar hedge below which while capping the potential upside also limits losses)!



Though most public companies, including Wall Street firms, have policies that ban hedging, albeit only their most senior executives, the practice is widespread at the lower levels. However, such hedges often put the executives interest in direct conflict with those of their company.

It is clear that reforming executive compensation is far from easy. Financial market reform is at best a moving target. Regulators and policy-makers have to be quick to respond to emergent distortions, if not be one-step ahead of the market. In practical terms, this means that instead of one-time enactments, they need to have legislations and rules that are constantly evolving in response to emergent scenarios.