Previously due to strict regulations and less opportunities for making profits manager incentives had limited upsides. But in today’s deregulated and competitive environment financial executives are paid mainly on how they have performed compared to certain benchmark; it’s not measured in absolute terms. Mostly this benchmark is peer performance or a particular index which they trade or track. Like a fund manager’s performance that is trading over S&P 500 would be measured on how he/the portfolio has performed compared to the S&P 500.

What investors are majorly looking is how has a manager outperformed the benchmark (i.e. alpha) or his peers and that’s how he gets the payment; the more the alpha the more he gets paid. When we look at other industries a financial manager’s major aim is to increase the shareholder’s wealth. The more the wealth creation the more is the pay of the executive. Also if the investors are dissatisfied they would take their money somewhere else, ending the job of the manager.

Since compensation is related to returns, there is less downside and more upside in generating returns, implying there is rewards for positive returns which exceed the penalties for negative returns.  For example we look at the hedge fund payment structure. If hedge funds payment to their managers is seen they have a ‘high water mark’ clause which implies that suppose in year 1 the return is 110% the manager would get paid for the 10% earnings, the next year its 125% so he will get paid for increasing the return by 15%. But then in the third year the return falls to 105% that particular year the manager gets no payment in fact he won’t be paid till the return crosses 125% as that’s the highest return he has achieved till date.

This situation creates a moral hazard as the financial executives think about increasing the wealth or their firm or the investors or shareholders and thus their wealth also but forget about risks that they would be exposing the firm to and apart from their firms the other firms, the whole industry, and economy as a whole.

Thus we see that managers are induced to take higher risks so that they can earn more. This has bought about a few practices by the managers which results in taking excessive risks. A couple of those would be hidden tail risk and herding behavior.

Hidden tail risk usually yields positive returns. However, this risk also carries a possibility of huge negative returns. For example, guarantee selling by the insurance companies against defaulting companies in the credit derivatives market. IN normal times the insurance companies make profits by collecting the premiums from the guarantee buyers. But if the company defaults, the guarantor is obliged to pay out a hefty amount. Hidden tail risks are not only unobservable to the investors but they are typically not included in the comparison benchmark. Thus the manager will be able to earn higher returns which would distinguish a manager from both his peers as well as the benchmark, leading to higher rewards in compensation. Also another advantage for the managers is that the high returns so generated could last for long period of time before showing their true colors in the event of a high negative outcome.

Herding occurs when a manger follows the trend and adopts the similar investment strategies as their peer group. Herding drives assets prices away from their fundamentals and the odds of succeeding by going against the massive trend is slight. There is a relatively limited time horizon to reverse any relative negative trend so there is a higher possibility of losing investors if the returns drift in the wrong direction. Herding provides a manager insurance that he would not underperform the benchmark. For example, the investment manager may buy a single stock from a major index, such as S&P 500, that moves in the same direction as that of the index, but with less volatility than other similar stocks in the index. While realizing that the stock may be overvalued, the investment manager’s herding behavior follows the logic that his performance will not be worse than the benchmark if in fact the index heads downwards.

Thus the subprime crisis was result of such managers’ behaviors where they failed to understand where risks were and how much risk should be sufficient in the drive to earn higher returns. Most managers were just making loans to the borrowers, especially the NINJA loans with thinking about the future as to whether these loans would be paid up or not, and they did not care much as these loans were securitized so the bank would not have bear the brunt but some investor who had made the investment would. Also there was immense financial engineering just to increase the rewards for them.

Therefore we see that if there were regulations in place which were before then such risks could have been curtailed. Already most managers earn about one-fifth of their American counterparts. So capping a manager’s salary will allow them to keep risks under control and not be greedy and take decisions which are for their own benefit and not for the economy as a whole.

But capping a manager’s pay would reduce the talent that is attracted to such jobs, as talent in such areas is pretty less. Also these managers would use less of their talent than they could have actually done. The bigger problem would be that the C.E.O’s salary would be capped and not for others, so most talented people would try to become lawyers or fund operators etc than becoming the top boss.

Now looking at large companies they would always want the best talent as a few good decisions could change the entire face of the bottom line. A 1% increase in profits for a 10 billion company is huge and therefore higher payment is considered worth paying to a manager. Thus we see that most companies where executive decisions play a vital role are willing to pay enormous sums to good and impressive managers. Many complain that the C.E.O. appoints there friends or relatives on the board which allows them to sanction such enormous packages for themselves but this practice of appointment has prevailed for long and just cannot be a reason for capping salaries.

Now we have argued that previously managers had lowers pay but then the point to note is the most companies have themselves grown in size so the compensation they should pay must also rise. A study has found that C.E.O. compensation at large companies grew six fold between 1980 and 2003, the same as the market-cap growth of the businesses.

Also the way to become the top executives changed with times. Previously one had to spend his entire life with the company to get to that coveted position but in current times executives from other industries or companies are bought into top management. A classic example is of the former boss of IBM Louis V. Gerstner Jr. who bought about the massive turnaround in the then struggling company; he heading RJR Nabisco when he was bought into IBM.

One can argue the amount of payment made to C.E.O. regardless of performance but then there in no certainty about the moment when a magical decision can come changing the fate of the entire company. Also most executives are removed from the positions if they underperform or not deliver what is expected in a span of one or two years. Thus the competition itself assures that the best are paid the best.

Therefore from all the arguments stated above we see that manager’s unlimited pay has high risks attached but then they should be met at the firm level. The firm should have a proper risk management technique which sees that excessive risks are not taken. As far as capping the pay is concerned it is not the right idea to go ahead with. Instead marginal tax rates should be increased so that higher earnings are taxed higher. This is also good for the economy as it will try to reduce the disparity of income and is consistent with taxing the rich more than poor.

United States President has capped the executive pay to $500,000 but that’s just with the money given in the bailouts, which seems correct as managers should not be paid for their mistakes out of tax payers hard earned money and also such a move is deterrent for similar future action as if the incentives were not capped and the managers went ahead cashing the rewards probably the next subprime crisis was not far.

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