Friday, December 19, 2008

Wall Street: Changing one incentive structure

I worked on Wall Street for 10 years and recently re-upped with a hedge fund with an eye to taking advantage of the current crisis to make a little money – at least for a while. So I know something about the perverse incentive structures on Wall Street. There are many of them, but today I want to discuss the bonus problem.

There are a number of problems with Wall Street bonuses, one of them being that they are disproportionate to other, in many cases more worthwhile, professions. This has caused Wall Street to drain off many very talented people from other parts of the economy where rather than shuffling bits of paper about making numerical profits, they could be curing disease or figuring out how to make a better solar panel. I do not joke: many of the main “quants” I worked with were chemists, physicists, mathematicians, statisticians etc whose talents could have been (and hopefully will be) employed better.

More importantly, the bonus cycle causes a number of other perverse behaviors. Since the base salary does not provide the lifestyle most employees live beyond their monthly means and rely on the bonus to bail them out at the end of the year. The problem here is that it has become impossible for bonuses to be paid only for exceptional work. Rather as it is the lion’s share of annual income it is expected. “No Bone” is hardly ever “No Bone” but rather some smaller amount. A true zero bonus has often been used as a sign that it is time for a person to move on.

What is to be done?

I think that the bonus culture is entrenched and could be reformed so that it works as it should. I would have the bonus carved into three equal tranches. The first would be the cash bonus as it is now. The second would be an all equity tranche that would vest one third after three years, and another third after four and a final one after five. The final equal tranche would be paid after three years.

This way not only would the worker have an interest in the health of the firm, he would also have an incentive to not get himself fired (fired with cause and you lose your outstanding payments) and also not to lose money. If your contribution were ever negative, the firm would be able to claw back any or all of your future payments.

This way that trader I worked with who, in advance of the Russian Crisis, loaded up on Russian risk and was paid handsomely would not only have lost his job when it all went pear-shaped, he would also have lost most of his income from taking risks others of us warned him about. Instead he made a ton of money and walked away laughing even as the firm almost went under.

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