Monday, January 19, 2009

Partnering with Regulators

Traditionally, American businesspeople considered regulators a foe to be avoided, co-opted, or, if possible, vanquished. That’s the wrong attitude, especially in the current environment. As Lord Melbourne (William Lamb, 1779-1848) once said, “Those who resist improvements as innovations will soon have to accept innovations that are not improvements.”

Regulators, good ones anyway, curb business’s worst excesses. Where business seeks market power, regulators strive for competition. Where business yearns for high returns, regulators desire systemic safety. Rather than butt heads time again, regulators and the regulated ought to sit down as partners and figure out how both sides can achieve their goals.

Possibilities abound but compensation reform holds supreme promise. From the corner office to the mailroom, people usually do precisely what they are incentivized to do. Tell a pastry chef he can eat his mistakes and you’ll soon have a fat guy in the bakery. Pay workers by the hour and you will have to supervise them much more closely than if you pay them by the piece. Give a CEO stock options and the stock will rise, hopefully due to increased efficiency but quite possibly because of accounting shenanigans.

Companies that get the compensation question right thrive. Consider Guardian Life Insurance Company of America (GLICA), a successful mid-sized mutual life insurer in an industry now dominated by joint stock giants. Although owned by its policyholders, GLICA did not become a stodgy mutual dinosaur because its general agents, firms that sold mostly Guardian products, played the same role that large blockholders play in the governance of stock corporations and basically browbeat Guardian’s management into remaining competitive. GLICA’s managers also devised a long-term incentive program for themselves, which pays off handsomely upon retirement, thus closely aligning their interests with those of their policyholders.

Conversely, business history is littered with the corpses of companies that got the compensation question wrong. Bear Stearns, Merrill Lynch, Lehman Brothers and the other investment banks that stumbled during the financial crisis of 2007-8 are the most recent major examples. Traditionally, investment banks were partnerships. With their all at stake, the partners took small risks while building equity for the long haul. After the investment banks went public, however, managerial incentives changed dramatically. The game then became to earn big returns and gigantic annual bonuses by taking huge risks, stockholders and other long term stakeholders be damned.

It should be an invariable rule of business never to pay anyone until the ultimate consequences of their contribution is clear, when economic profits are actually accrued rather than mere accounting profits booked. Paying mortgage originators full commissions at closing has failed seven straight times in U.S. history. Instead, originators should be paid over a period of five or seven years, and only for mortgages that are not in default. (Analogously, life insurance agents receive their commissions over years to incentivize them to sign up good risks.) Similarly, managers should be incentivized to attain, and then maintain, their stock price target, not merely to puff up the stock for a fleeting moment.

Businesspeople generally concede these points but counter that competitive markets for talent preclude them from deferring much compensation for long. The best people, they claim, would flee to competitors willing to pay up sooner. Here is where a strong partnership with a good regulator can work wonders. Businesses should sit down with their regulators and come up with incentive compatible compensation structure guidelines for every major job category in their respective industries. The regulators should then enforce those guidelines so no company can complain about being at a competitive disadvantage. Where appropriate, the regulators should seek international cooperation. Most importantly, they need to watch out for attempts to find loopholes and changing industry conditions. To ensure that they remain attentive, regulators ought to think long and hard about their own incentive structures.


SWMTulsa said...

I watched your appearance on What'$ Next? again through Hulu. I was wondering if one of your books goes into the details you outlined on your PowerPoint presentation, especially the seven failures of mortgage securitization mentioned in this post. If so, how can I buy a copy?

Anonymous said...

SWMTulsa ... I have a number of books coming out:
in March coming out of Wiley I'm a contributor a volume called Restoring Financial Stability
in May/June out of Columbia UP/SSRC I'm the editor and contributor of Bailouts: Public Money, Private Profit
and I hope to announce soon a book forthcoming in the Fall.

None of them will address the 6 previous mortgage securitization failures in detail. The source on that is Kenneth Snowden in Michael Bordo and Richard Sylla, eds., Anglo-American Financial Systems: Institutions and Markets in the Twentieth Century (1995), which is available in many university libraries.

Robert Wright