Compensation Structure At Banks: The Nonsense Has To End

A contentious issue at the upcoming G-20 meetings in Pittsburgh by the world’s leading financial system legislators and regulators is the one of so-called “executive” compensation within banks. For the sake of focusing on the real issue, let’s identify the problem. It is not about compensation paid to managers of financial services institutions, which is no different than the issue of compensating executives of any corporation, which ought to be a private matter between shareholders, the corporate board of directors and the persons involved.

No, the issue is one of the compensation structures at the financial institutions like banks and brokers for what is known as “producers” and whether these structures need to be regulated for purposes of maintaining stability and integrity of the global financial system. This is the problem that I believed caused the crash of the financial system, and it must be resolved quickly.

http://online.wsj.com/article/SB125123683173958325.html

Bankers a few years ago started this program of toaster giveaways to people who set up new accounts. No big deal really, but let’s say the toaster was replaced by a Ford Focus giveaway courtesy of the bank’s owners, the shareholders, who by the way did not agree with the practice but could not stop it. And let’s say the program was started by the sales team at Humungous Bank & Broker (HB&B) who determined on some statistical basis that each new account was really worth $40,000, and that the giveaway costing $20,000 was justified, and that the salesperson involved should be entitled to a 25% commission for bringing in the account, which would be $10,000, leaving HB&B with a gain of $10,000. Believing their account might be worth say $2,000 to the bank, the people lined up around the block, waiting to drive away with a $20,000 gift. Each salesman took in 4 new clients an hour, say 25 a day, earning $250,000 a day, $5 million a month, $60 million a year. The assets of the bank were increased by the same amount per salesperson, ie, $40,000 less direct costs of $20,000 for the car and $10,000 for the salesperson. A couple years down the road, the bank discovers these assets are non-performing in the sense that the $30,000 outlay was returning maybe $300 per client in profitable business, ie, a 1% annual return, which is clearly not an economic return. Aha, the executive management of the bank says, we’ve got another housing market mortgage loan crisis on our hands, so we’ll have to write down these assets. Another problem fixed.

The numbers here don’t make sense. What I am writing about is the principle of permitting management bonused people and sales commissioned people inside banks to be able to use financial engineering to create temporary value that ends up with dollars in their pockets at the expense of shareholders. Sooner or later the whole bank becomes unstable and depositors and staff become impacted. Then as HB&B is deemed to be too big to fail, the taxpayer has to come to the rescue now that Henry Paulson organized the Fed take-over of the Treasury.

The question to ask is why are the taxpayers, the depositors, shareholders and administrative staff of the banks getting screwed because of self-regulatory organizations like HB&B and the Fed running amok?

Self-regulation in the financial services industry is a failure because it is managed by executive managers working hand in glove with the big producers of these banks. They are engineering ridiculous products, like betting on the weather or carbon emissions, and stuff like that, with one goal in mind, which is how much are they going to be paid. The cart is driving the horse.

The nonsense has to end. If there truly is an international Financial Stability Board (FSB) that works, it has to address this problem. Bankers should not be commissioned salespersons. Profits should be earned for the shareholders. Bonuses should be restricted to a small percentage of salary, such as maybe 15 or 20 percent. The free employment market should dictate the value of any person, not the schemes that person gets involved in at the place of employment. Truly independent members of the board should oversee and approve all executive and producer level employment contracts within a financial service company. Other than legislating the employment structure that the FSB approves, the G-20 country governments ought to keep their hands off and their noses out of private business.

http://www.financialstabilityboard.org/members/links.htm

http://www.financialstabilityboard.org/about/overview.htm

Given that the issue is now a political one because the taxpayer was forced to get involved, and it’s now a global problem, it may take some time to work out the ultimate solution, but I don’t think the parties will ever get there if they don’t focus on the real problem. A bank should not be a rabbit warren for entrepreneurs who come and go. A bank needs to be a rock.

Have a good day.

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