Questions of merit

by on September 21, 2009 at 3:25 pm in Economics | Permalink

Can it really be that the G20 is about to adopt elaborate
banker-compensation rules without a single study showing that
compensation incentives contributed to the crisis??

If anyone knows of any such studies, PLEASE CONTACT ME at edcritrev at gmail dot com.

That is Jeffrey Friedman, from the comments.  Please leave your reading suggestions in the comments here.  So far no one in the previous set of comments has come up with anything statistical, not even weak evidence.  Nada.  Please don't let the world violate Cowen's 2nd Law, which promises: "There's a literature on everything."

1 Diversity September 21, 2009 at 3:32 pm

Do we normally ask for a review of evidence of their effects before changing incentives which appear perverse? Shouldn’t the burden off proof be on those who want to keep any apparently perverse incentive?

2 Lance September 21, 2009 at 3:39 pm

Here’s a paper that says certain compensation forms affect the amount of leverage taken by a firm:

I haven’t seen any papers lay out a direct relation, but more of speculation regarding the relation between firm risk-taking activities and the way compensation is paid out.

You might want to check out Samwick & Aggarwal’s work.

3 Andy September 21, 2009 at 3:49 pm

what is cowen’s first law?

4 Bill September 21, 2009 at 4:18 pm

Uh, I just lent those b—ards a whole bunch of money and they did not take a haircut. Doesn’t sound like the market is working.

Do you think we are all fools, or just some of us? Maybe we should study this for five years, or hire a consultant who would say something like, oh, they took some of their comp in stock, so that proves they had their interests aligned with the principal. Look at an earlier post and see how that argument was shot down.

By the way, this isn’t libertarianism or schmibertarianism, it is common sense: if you fail and ask me to guarantee your business so that you will not damage me, I have the right to align your interests with mine. If you claim you are too big to fail, and want to suck on that large mammary gland of the government, expect some strings. Or else you’re just a thief.

5 The Epicurean Dealmaker September 21, 2009 at 4:29 pm

Sounds like you’re setting yourself up for a Popperian falsification moment, Tyler. We’ll see.

In the meantime, I’ll say this much. Based on my completely unscientific review of the tendentious horsehockey and ignorant twaddle published in the mainstream media and blogosphere so far on the topic, I can assure you that virtually no-one out there with a forceful opinion knows what the hell he or she is talking about. Read the typical screed, and you will discover a blowhard who cannot differentiate or distinguish among executives, commercial bankers, investment bankers, and traders. Pitiful.

I sent Mr. Friedman my semi-comprehensive version of some of the highlights (lowlights?) so far: I suspect it is not what he is looking for. Furthermore, I’ll be damned if I remember even a single statistic in the lot.

Take heart, however: a flotilla of future PhD theses has been floated on less.

6 Blargh September 21, 2009 at 4:45 pm

Weren’t most of the “bonuses” income that was guaranteed to be paid out at the end of the year? I thought that was called “salary”.

7 Bill September 21, 2009 at 5:00 pm

Litigation reveals tons of data, and from it you should be able to test any hypothesis you want. Bankruptcy records will also be a treasure trove of info as will Congressional hearings and the current, just starting investigation. So, anyone who wants to have a short career extolling the argument that incentives had no effect, please be my guest.

8 hedge fund guy September 21, 2009 at 5:16 pm

Oh please. I’m a professional trader who takes vast amounts of leverage using other people’s money. If you think my behavior — and for that matter, the behavior of my many current and former colleagues, counterparts, friends and enemies on Wall Street — was not minutely influenced by my compensation incentives — down to the precise selection and timing of individual trades — then you must be seriously naive.

Tyler, you’re an economist, you know the importance of incentives. Why is this even an issue?

9 Joe September 21, 2009 at 5:18 pm

I “shutter” once worked at an investment bank as a “shutter” investment banker. The first problem is that people are conflating bankers and traders.

Limiting the pay of an M&A banker is going to assure that a worse and worse breed of human ends up doing advisory work at large banks. With pay restricted, and hours still absurd, only the truly masochistic and/or megalomaniacal will stick around, while the last remaining intelligent and/or thoughtful bankers flee to whatever part of the financial landscape remains outside of Leviathan’s grasp. This will result in worse advice (hard to imagine it could get worse, but it can!) to corporate America. This will have no effect though on the fragility or stability of the financial system.

Now limiting pay for traders is a bit more understandable. But even then, the question is will that really solve the problem? If you go back to 2005 and 2006 and asked the folks who structure, originate and trade CDOs whether having their bonus paid out over 3 years would effect the types of trades they make, most would say no. At the time, most thought that the super senior tranche of a CDO was money good. Would a 3 year clawback have made the marginal trader re-examine the embedded assumptions? Possibly. But it’s not like there weren’t people all across Wall Street loudly questioning those assumptions. In fact, much of the Wall Street machinery fought back against the arguments, so they were known to them. I’m not convinced that introducing a clawback would have made them change their minds. They really really believed in their models. Also, they were paid in restricted stock that vests over 3 years anyway, so its not like individually they were thinking “who cares if I blow up the place”?

Finally, we need to look beyond bankers and traders for the source of the problem. What about the funding desks inside the Treasurers office? What about risk management? What about senior management? Traders and bankers are going to do what they do, it’s up to the institution to harness them in.

This will be a total failure of misguided legislation if it is attempted. For anyone who thinks otherwise, go back to the early 90’s “reforms” of executive compensation. Remember that one?? The one that limited the deductability of salaries but not compensation paid in the form of stock options. How’d that work out?

10 C September 21, 2009 at 5:29 pm

I agree with the commentators arguing that the perverse incentives are plain to see. It is merely factually correct that if traders make big money they get big +ve bonuses, while if they lose a lot of money, they dont have symmetrical -ve bonuses. Rather, they, AT WORST, will be paid their salary, regardless of what they do with other peoples’ money. Or they may take a golden parachute and get the hell out of there.


I’m unsure of how it would even be possible to construct a positive *proof* that this perverse incentive caused the financial crisis. In order to do that one would need a counter-factual. That is, you would have to positively show that without perverse incentives this crisis would not have come about.

However, there are grave difficulties in trying to prove what would have happened had some other payment system been in place – which it was not.

The best we can do is use some reason and deduction and observe that perverse incentives are bad anyway – whether or not they had a big impact on this crisis.

11 John Pertz September 21, 2009 at 5:44 pm

The best part of this discussion is that the people who want to regulate C.E.O compensation speak as if they know the most socially optimal route for regulating their pay. That is what is so hilarious about this discussion. I honestly have not seen the proponents of this reform do anything but make very veiled generalizations. Also, if the government does regulate the design of compensation packages and we get another crash, what does that say about the reformers’ thesis?

At the end of the day this discussion is nothing more than political tripe trying to model itself as positive reform. This discussion is so out in left field compared to other serious issues regarding the crisis.

12 Doug September 21, 2009 at 5:51 pm

Shutter is a thing that you shut over your windows, shudder is when your body shakes.

13 Commenterlein September 21, 2009 at 5:59 pm

Rudi Fahlenbrach and Rene Stulz have some evidence against the hypothesis that bad incentives were behind the banking crisis:

14 Brian September 21, 2009 at 6:57 pm

The libertarian position would be that the burden of proof is on the coercive use of government power.

Well, that would presumptively mean we’d have to close up the entire banking system.

The banking system is no more a free market in any modern nation than is the Post Office or Public Education. The problem is that we’re paying bankers millions of dollars a year to rent seek on Government guarantees we all pay for.

Schoolteachers and letter carriers would like to get in on that action. But they’re not going to pretend to be rugged individuals in a free market.

15 mulp September 21, 2009 at 7:16 pm

Can anyone point to evidence that bonuses prevented systematic risk taking leading to the firm’s demise or massive losses?

16 jimi September 21, 2009 at 8:02 pm

Uh, what’s the Cowen’s 1st Law?

17 Yancey Ward September 21, 2009 at 9:21 pm

There is something wrong with Cowen’s 1st Law.

18 babar September 21, 2009 at 10:21 pm


i was not being critical.
i was not saying that your positions were inconsistent.
i was just pointing out that you had a very clear position that became a different very clear position after a key external data point changed.
i work with traders, and the way you incorporated data, going from one state where you had absolute clarity to another where you had absolute clarity, is a common trait among the traders i’ve known.
most people i know, the non-trader kind, do not generally have such clarity.

19 pinus September 21, 2009 at 10:51 pm

People in this discussion who argue that the case of incentives is blatant are conflating two things. Take “hedge fund guy” as a representative. He argues:

“Tyler, you’re an economist, you know the importance of incentives. Why is this even an issue?”

But this was not the question. Of course, incentives influence behavior. But in what direction does a particular scheme shape the incentives? Which directions are “desirable” and which are less?

The simplified argument presented by many proponents of regulation, namely that it’s simply “high bonuses” that caused (or significantly contributed to) the banking crisis is clearly wrong. But have there been incentive schemes that went in the “undesirable” direction which actually substantially contributed to the crisis? Here, as the literature suggests, the answer is unclear at best. And this is what Tyler is after.

20 Justaguy September 22, 2009 at 12:17 am

Karen Ho made this argument in Liquidated, which is her ethnographic account of investment bankers on Wall St..
She describes an institutional culture where people experience rapid job turn over and are compensated based on the short term impact on deals, with no real incentive to worry about the long term returns.

21 Ken Rhodes September 22, 2009 at 9:35 am

>>Can it really be that the G20 is about to adopt elaborate banker-compensation rules without a single study showing that compensation incentives contributed to the crisis>>

Well, let’s see … we have a melt-down of this proportion once or twice a century. How large a sample size should we try to accumulate for your “study?” Or alternatively, what studies have been done showing that nuculear weapons kill more people than conventional weapons? None, of course, since it isn’t even true. I guess we oughta stop trying to control nuclear proliferation, too.

22 babar September 22, 2009 at 11:08 am


however, it would be an interesting question to ask (since you told us that your trading behavior is affected by your compensation — duh) how your opinion on bailouts and compensation is affected by your personal situation re:compensation. were/are those two outcomes the most rewarding for you?

> I’ll fall back on my experience. And that experience has been that the current incentive schemes encourage short-termism, over-leveraging, fiduciary neglect, groupthink and self-delusion.

i have not much to add here, but in my experience this is completely true.

i’d also add that in my experience high compensation for traders does not necessarily guarantee high quality. it certainly makes for high competition for trader jobs, but i’ve worked with senior traders who couldn’t handle simple concepts (“why did my portfolio value go down? all my stocks went up! uh, your positions were in euros, and we measure pnl in dollars….”)

23 Gabe September 22, 2009 at 11:46 am

“My first preference would be no bailouts, and no limits on pay. That didn’t happen; the Feds stepped in and rescued everyone. I think this was a mistake, but I can’t dwell on the past; the world has changed.”


“Given this new state of the world (ie, given the bailouts), my next preference is that the government controls bankers’ pay.”

I haven’t followed the actual proposals details, but given what I have seen in the past the same bastards that stole money from us will now use the moral hazard justification(which is a great argument) to somehow create legislation that totally misses the point. Instead the new rules will hinder politically weak competitors while the Goldman Sachs of the world skillfully move through loopholes and installed backdoors.

24 Gabe September 22, 2009 at 11:56 am

Glen Tomkins :

Corporate governence took a serious turn towards scam when the government stepped in and set up rules encouraging every know-nothing in the world to funnel his dumb money into a 401k plan.

Fidelity loved it(CFA’s making a couple hundred basis points every year for tracking the S&P 500), Wall street loved it(more dumb money to play front running games with), CEO’s loved it(since they’d have no more nosy investors watching their board meetings)…the union workers and middle managers though they were becoming like the rich guys…but many are finding out what it is like to have a bag placed over their heads and get punched in the face…most of them are so stupid they will be thankful for it.

25 rob September 22, 2009 at 1:32 pm

Do the many case studies of Enron count as a study? A place where the risk managers were told to shut up or be fired?

26 Gabe September 22, 2009 at 4:52 pm

“And I don’t see what events will make the necessity clear short of the collapse of these markets, by which time it will be too late.”

Right now it is only common sense to expect more destruction as each new bad event is blamed on the “free market” and the “lack of regulation”. The ONLY thing that I see that can counter this is a very well educated movement of trans-partisian/austro/paleo libertarians. The movement cannot come out of the republicans or democrats both are too statist and too corrupt.

27 v September 23, 2009 at 12:02 pm

Executive Compensation and Policy Choices at U.S. Commercial Banks
Robert DeYoung, University of Kansas
Emma Peng, Fordham University
Meng Yan, Fordham University

Bank CEO Incentives and the Credit Crisis
Rüdiger Fahlenbrach, Ecole Polytechnique Fédérale de Lausanne
René Stulz, Ohio State University

Corporate Governance in the Recent Financial Crisis: Evidence from Financial Institutions Worldwide
David Erkens, University of Southern California
Mingyi Hung, University of Southern California
Pedro Matos, University of Southern California

28 Gabe September 23, 2009 at 5:30 pm

This is the job of a court economist. Come up with intellectual defense for a power grab by the state. When enough eggheads convince themselves that they are right and the power grab needs to take place, for the purpose of “efficiency”, “correcting market failure”, “social justice”, “collective guilt” etc, then the government grabs the power. Once new powers are grabbed they are abused as quickly and efficiently as possible. Political leaders that are the most able to convert new powers into increases in the size of leviathan are worshipped by court historians and held up as heros to the state educated children.

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