Executive Compensation and the Financial Crisis: A Problem In Search of a Solution (Still) (Part 3)

We are examining whether compensation practices that were identified as a possible cause of the financial crisis have changed.       

What are some of the factors that propelled compensation in the pre-crisis period to such astronomical heights?  The CII sponsored report (Wall Street Pay, Size, Structure and Significance for Shareowners,  Paul Hodgson, Senior Research Associate, with Greg Ruel, Advisory Services Manager, and Michelle Lamb, Research Associate, The Corporate Library, Nov. 2010), identified as a root cause the use by large financial institutions of a formula borrowed from the partnership area.

The use of a partnership approach to compensation arose because many of the financial institutions at one time used this structure.  As the Report noted: 

• All of the pre-crisis Wall Street banks in the study, with one exception, JPMorgan Chase, were once partnerships. While Citigroup was not originally a partnership, Smith Barney, its investment bank arm, was once a partnership. And while Citigroup’s compensation policies did not evolve out of partnership pay policies, its inclusion of Wall Street firms in its peer group for compensation purposes had an immense influence indirectly. In many ways, these banks continued to take a partnership approach to compensation even after they became public companies, maintaining high levels of insider shareownership and “overhang” (equity reserved for use in incentive plans).

Such an approach contemplates the assignment of a percentage of net revenues to bonuses.  Again, as the Report explained:

• The typical partnership compensation plan distributes a portion of net income to the partners annually, often calculated as a percentage of total net income. In the decade leading up to 2008, many Wall Street banks routinely distributed between 50 – 60 percent of revenues to their employees as compensation. Even for a human capital-intensive industry, this was highly unusual. This compensation structure prevailed even at those firms that had not begun as partnerships.  And in the same way that partners often reinvest their partnership units in the firm, Wall Street executives received much of their compensation in equity and retained it.

The approach suggested that the total amount of compensation was not determined at the end of the process, after first assessing the performance of employees, but at the beginning.  In other words, the bonus pool of a specified amount would be spent irrespective of the aggregate contribution of employees.  Moreover, pools would presumably go up and down with the firm's net earnings, with shifts in bonuses motivated less by changes in performance and more by shifts in aggregate net earnings.

To reform compensation in this area, the partnership approach to compensation will need to change.