Attempting to Align Incentives: Banking Employees Edition

William Dudley, President of the New York Federal Reserve Bank, has an interesting idea on how to align the incentives of banking employees with the desires of bank regulators: Defer their bonus payments for 10 years and take regulatory fines out of the bonus pool. From his speech:

However, in contrast to the issue of trading risk, unethical and illegal behavior may take a much longer period of time—measured in many years—to surface and to be fully resolved.  For this reason, I believe that it is also important to have a component of deferred compensation that does not begin to vest for several years.  For example, the deferral period might be five years, with uniform vesting over an additional five years.  Given recent experience, a decade would seem to be a reasonable timeframe to provide sufficient time and space for any illegal actions or violations of the firm’s culture to materialize and fines and legal penalties realized.  As I will argue below, I also believe that this longer vesting portion of the deferred compensation should be debt as opposed to equity.

There is no question that banking incentives are broken. In the run up to the 2008 financial crisis employees were generating what looked like revenue in the short term, but ended up actually destroying many companies. Other companies were found to be systematically violating regulations designed to protect consumers, often because a simple cost benefit analysis can find that breaking the rules now and paying the fines later is more profitable than other approaches. Employees involved might accurately estimate that the chance of significant bonus clawbacks are generally close to zero percent. It's the shareholders who are stuck with the bill years after the bank's employees have walked away with between 40% to 50% of the revenue they generated.

What challenges will a Dudley style system encounter?

If the bonus pool is too lumped together the responsibility will be too diffuse to matter. Bear Stearns and Lehman both had significant employee stock ownership, and yet both firms went belly up in the 2008 crisis. Work will have to be done to ensure that the people causing the trouble are hit first and hardest by the problems they cause.

The deferal unilaterally changes the deal between shareholders and employees, and employees who do not want to wait for their bonus payments will leave the regulated sector. This may actually be a good thing, as FDIC insured institutions shouldn't be in the business of creating free call options for employees looking for a quick payout.

Base salaries will go up as a portion of total compensation to make up for slower payouts. Higher base salaries and smaller bonuses can cause employees to act in a more risk averse manner.

If this system isn't implemented unilaterally through all FDIC insured banks at once the employees with the most earnings potential will leave banks implementing this policy for greener pastures. Like reform to the modern college education system, reform has to come from the high status players or all at once.  

If a mandatory deferred compensation system was imposed from the top down as one of the requirements for deposit insurance or for institutions with access to the Federal Reserve discount window or for primary dealers then it has the potential to help more than harm. Shareholders win because they are more protected from the bad behavior of their employees. Citizens who are better protected against renegade employees and less likely to fund bank bailouts win, while certain employees who have been enjoying a "heads I win, tails you lose" dynamic are inconvenienced.

One caveat: Top down regulations on compensation are generally undesirable. Right now it is arguably too difficult to comply with all of the regulations that banks are supposed to follow - it's crazy that Citi needs 30,000 people working in compliance. This part of the system is also broken. And a congress plus a regulatory body trying to implement Dudley's reforms in some form may end up doing much more harm than good. But the financial industry, with both government subsidies and significant moral hazard, needs better ways to reign in broken incentives. Dudley's proposal gets a lot of things right.

Note to Silicon Valley: Jean Tirole is Relevant

Most Nobel Prize winning economic work is ignored by people trying to understand Silicon Valley, and for good reason. Subjects like macroeconomics and trade theory are rarely relevant for what people are doing on a day to day basis. Even the issue of efficient markets is a non-question. The venture capitalists don't believe and the people trying to automate wealth management accept it is true as a matter of faith.

But the work of Jean Tirole, who was awarded The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2014, is far more applicable to understanding the ecosystem of the technology sector. His work spanned many areas, but it is primarily on how to understand and regulate industries with few powerful firms. The Swedish Royal Academy of Sciences released a short summary of Jean Tirole's work here and their in-depth look is here - or just read Tyler Cowen's summary.

But why is this relevant for understanding the technology ecosystem? As Peter Thiel makes clear in Zero to One, one of the goals of a startup is to create an area where they are a monopoly. Google has an effective monopoly in online search. Facebook is the internet's most complete personal directory and the world's largest photo sharing company, LinkedIn owns everyone's online rolodex. Airbnb, Uber and many other successful new companies are successful because they essentially own their respective domains. Understanding the dynamics of market power is essential to understanding the most successful technology companies.

Once a firm is first to market, the question of what extent they should go to in order to deter competitors is a complicated question. In 1984, Jean Tirole and Drew Fudenberg plublished a paper on whether firms in various scenarios should over invest to protect their monopolies or if they should accept that they are going to face competition and stay lean and agile. The paper also highlights scenarios where the large initial investment to claim market share reduces a company's incentive to innovate, leaving them ripe for disruption after they have enjoyed the benefits of monopoly profits for a decade or two.

Another interesting question often faced today is that there is a company with a monopoly over one area, but how can they take that advantage to profit in other sectors? Tirole wrote many papers on vertical integration and monopoly power, and he did a literature survey of the field with Patrick Rey. Even if the goal of the literature is to figure out when to regulate these monopolies, companies can also use these strategies to find ways to expand their profit and market share. A mild version of this tactic is utilized by Microsoft when they release subpar versions of Microsoft Office to Mac so that power Excel users will be pushed to remain on the Windows platform.

Many startups are looking to build platform companies, where one company owns a two sided market and sells to both consumers and producers. Others may just want to better understand the incentives of the stores they are using to get their product to consumers. Jean was one of the first people to understand that maybe newspapers should be giving away their paper for free if that means they can charge businesses more for ads. This type of competition by the newspapers can drive their competitors out of business, but this seemingly monopolistic practice is benign - in many scenarios platform companies make is so everybody (except the platform competitors) wins. Here is a paper on Platform Competition that Tirole wrote with Jean-Charles Rochet - or better yet, a literature survey published three years later.  Alex Tabarrok and Vox have short posts addressing some of his work on platform markets.

This is only scratching the surface of his work, but it shows that many of the ideas driving value creation in Silicon Valley today have been analyzed in academia to a significant degree. These are complicated problems and sometimes returning to look at what the theory says can keep practitioners from making avoidable mistakes.  

Snapshots of our world: Assorted Links

1. Tim Harford uses the analogy of picking the fastest grocery store checkout line to explain the efficient market hypothesis. Ironically, the advent of self service aisles has created an option that lets customers get out of the grocery store


3. Welcome to the US, where everyone is guilty of something

4. And some things (literally things, not people) are guilty until proven innocent. (HT: MR)

5. Consumers in the US are spending more money on luxuries. All of them, not just the one percent.

6. A chart that highlights one of the impacts of the expansion of democracy to the masses. Presidents have to speak more simply in modern times. 

DFW: No such thing as atheism

I recently came across a collection of audio recordings by David Foster Wallace. Some of the short stories from Brief Interviews with Hideous Men are far more disturbing when I am forced to listen to every word and cannot just skim quickly past some of the more gruesome scenes. 

His commencement speech "This is Water" (transcript) is one of the more striking parts of the collection. This passage is towards the end of the piece:

Because here's something else that's weird but true: in the day-to day trenches of adult life, there is actually no such thing as atheism. There is no such thing as not worshipping. Everybody worships. The only choice we get is what to worship. And the compelling reason for maybe choosing some sort of god or spiritual-type thing to worship -- be it JC or Allah, be it YHWH or the Wiccan Mother Goddess, or the Four Noble Truths, or some inviolable set of ethical principles -- is that pretty much anything else you worship will eat you alive. If you worship money and things, if they are where you tap real meaning in life, then you will never have enough, never feel you have enough. It's the truth. Worship your body and beauty and sexual allure and you will always feel ugly. And when time and age start showing, you will die a million deaths before they finally grieve you. On one level, we all know this stuff already. It's been codified as myths, proverbs, clichés, epigrams, parables; the skeleton of every great story. The whole trick is keeping the truth up front in daily consciousness.

Worship power, you will end up feeling weak and afraid, and you will need ever more power over others to numb you to your own fear. Worship your intellect, being seen as smart, you will end up feeling stupid, a fraud, always on the verge of being found out. But the insidious thing about these forms of worship is not that they're evil or sinful, it's that they're unconscious. They are default settings.

It's worth noting that a trite message can still be important, true and undervalued.

Assorted Links

1. Bill Gross left Pimco. When some CEOs leave their companies the shareholders celebrate. In the case of Bill Gross leaving the shareholders of Pimco's parent company, Allianz, decided that the company was worth about 3.8 billion dollars less than the day before. Part of this 3.8 billion dollars is related to new information about the severity of the problems that caused Gross to leave in the first place. But because Bill Gross chose to join Janus Capital the same day, we are left with an estimate of about how much the market values the human capital of Bill Gross - slightly under $900 million dollars.

2. Clay Shirky tries to help his students stop multitasking. Apparently there are many drawbacks to multitasking and I should stop making assorted link posts. (fortunately for me these posts are generally a symptom of my multitasking and not one of its causes)

3. Regulatory capture in the financial sector: Goldman Sachs vs the Fed. We should expect these problems to persist for as long as regulators are hoping to find work for the companies they are regulating (or companies doing a significant amount of business with the regulated companies).

It's interesting to see the PR machine of Goldman go to work on damage control. First the response is "This person tried to get a job from us many times" implying that the employee was merely bitter. They also highlighted the fact that Goldman did have a conflict of interest policy and thus the whistle-blower was wrong (without any emphasis as to whether or not it was effective). Shortly thereafter, there is a massive change in Goldman's conflict of interest policy. 

The Best People on the Internet

Are those who don't comment. So those who accidentally browse the comment section of popular websites should take solace in the fact that comments are not a reflection of the general population.

Via slate and the original paper.

While the study focuses on the behavior of trolls, it's interesting to note that people who are interested in debating issues also have more traits associated with Machiavellianism and sadism than others.

An implication of the BABA IPO

After the Alibaba IPO, the market is on average expecting that Yahoo's CEO Marissa Mayer is going to destroy $11 billion dollars in shareholder value. That's how much the operating company of Yahoo is valued at when stripped of its cash, Alibaba and Yahoo Japan holdings.  

This is actually a little harsh. There are some tax issues which would lower the $11 billion number slightly. On top of this - Alibaba is currently very hard for an arbitrager to short. Once it becomes easier to borrow Alibaba stock it is likely that the implicit negative valuation of the core Yahoo business will shrink.

Investors are guessing that a significant portion of proceeds from Yahoo's Alibaba stake are going to go towards value destroying acquisitions that boost the importance of the CEO at the expense of shareholders. When Facebook bought Instagram, they made a good decision to buy a nascent competitor who understood the mobile space. When Yahoo bought Tumblr for $1.1 billion, Mayer spent $750 million of that cost on intangible assets in an attempt to try make Yahoo relevant/cool, with the side effect that the person running Yahoo would also be more relevant*. 

Mayer can prove the doubters wrong in one of two ways. The easiest way is to find a tax advantageous way to return money and shares to the shareholders. The harder way is to make acquisitions like the market expects, but to buy companies that will actually generate earnings for the core operating company.

Mayer taking the hard approach is the most likely, but she has committed to returning at least 50% of the proceeds of the Alibaba IPO to Yahoo shareholders. Given that this payback, it is really hard to destroy as much value as the market is currently pricing in . They are probably paying too much attention to Yahoo's past acquisitions of GeoCities and Broadcast.com. 

And given how cheaply Yahoo is currently trading, this entire discussion could be moot. Yahoo itself could be bought before we have a chance to find out what Mayer would have done with its influx of money.


*It's important to note that Tumblr's value has gone up if value is measured on a basis of how many users the service has, but it has disappointed the market in that it has been harder than expected to generate revenue from these users.

Assorted Links

1. One of the scariest things for a start up in the valley today is the prospect of a down round. Interestingly enough, Facebook had one in 2009. Their value was over $10 billion and it was in the midst of a financial crisis, but it's still interesting to note that it happened.

2. Peter Thiel did an AMA. I for one have always thought that capitalism was the private ownership of the means of production. But the insight that the best investments are outside of commodified industries almost sounds like the best businesses are those with a moat or long lasting competitive advantage. This theme has helped other investors compound significant amounts of capital for a long time.

3. Positive news on the US patent front. But there is a long way to go.

4. The concept of time optimization, engaging in activities at unusual time to get better use out of underutilized resources, is severely undervalued in most people's everyday life. This advice from Tyler Cowen about eating early in the evening before restaurants get sloppy is interesting. It's best for those who either do not need to eat with others or who have enough status to convince others to eat with them at an unconventional time.

Revolving Door Politics Needs a Systemic Solution

Eric Cantor, the former House Majority Leader who recently lost his primary, demonstrates a major hole in the current campaign finance reform agenda via his recent actions.

Long accused of being too friendly to Wall Street, Cantor is now being paid very well to work for a boutique investment bank. His contract includes a relatively common provision in which leaving to go back to work in politics is essentially encouraged:

Unvested initial RSUs and unvested incentive RSUs will be forfeited if Group LP terminates Mr. Cantor for cause or if Mr. Cantor terminates his employment other than (i) for good reason or (ii) after the second anniversary of the grant date, to take a full-time elected or appointed position in federal government, state government, or a national political party.

So not only are they monetizing his connections now, but they are paying him millions of dollars and assuming that he will go back into politics after two years. This is a very common practice. Rahm Emanuel also decided to monetize his political connections after his time with the Clinton White House. Then in late 2008 he was part of an incoming Obama team, part of whose job was to determine whether or not the bail out of the financial system should retain the status quo in which too big to fail banks could make the equivalent of "Heads I win, tails you lose" bets. It's hard to imagine that a group of people who know that multimillion dollar jobs are easily available from the companies whose fates are in their hands will be able to remain unbiased. 

More egregiously, Raj Date worked as deputy director of the Consumer Financial Protection Bureau where he helped create regulations that drove banks out of an area of the mortgage business and then started a financial company to take advantage of the hole in the market he helped create. Less ambitious regulators might not create business opportunities for themselves quite so directly, but the incentives and opportunities for them to do this are there.

Ideas like the PAC to end all PACs would reform the financing of elections, letting congressmen study legislation more closely if they didn't have to spend as much time fundraising. But this does nothing about where their big pay days come from after leaving office. Even under a revised system, any officials and elected representatives can still choose to spend a significant portion of their time thinking about how they can help the very same people they are soliciting political donations from today. The practice doesn't have to be obvious, they don't even need to get jobs directly from the influentials they help. If the officials/politicians are owed favors they can call in favors while working for their new employer and everything will look above board.

It's difficult to quantify the potential positive impact of campaign finance reform compared to closing the revolving door between business and government, but on a relative basis solutions for the revolving door problem deserves much more attention.

Right now the revolving door is only brought up during partisan high profile nominations (when the partisans will bring up anything that makes a nominee look bad) or when those appointed officials are perceived to be misbehaving (like with Tom Wheeler and the FCC's and net neutrality rules).  And so the US still lacks broad systemic rules to stop those who create or enforce legislation and regulation from immediately getting high profile jobs in the private sector where they can monetize their owed favors and connections. Unless the officials are making decisions directly related to government contracts it doesn't matter where they work. And activists don't seem to be putting actionable solutions on the table - outing the people involved in revolving door politics or trying to block a few nominations seems to be as far as most groups will go.

Partially this is because there is less incentive for people in power on either side of the aisle to bring further attention to a practice that helps themselves or at least helps their friends and colleagues. Finance reform has a natural constuency among legislators - those who aren't as good at raising money and those who dislike the process of raising money can support it or at least be lukewarm about the idea. On top of this, those on the left don't favor revolving door storylines that paint government officials in a negative light when the problem of attracting good people to government work and getting voters to back additional progressive policies is a higher priority. 

And the op-ed writers pushing for campaign finance reform have an extra selfish incentive to do so - if generic rich people have a harder time making their voice heard then the ones in control of the media, such as the writers who have a column every Sunday, will have more impact.  They don't have the same incentive to talk about system wide solutions to revolving door politics. Pushing for policies that would hurt the economic wellbeing of legislators and officials could cause them to lose the access that makes their job significantly easier. 

Like campaign finance reform, the solution to the revolving door issue can get messy and complicated once implementation is considered.  France imposes a three year waiting period between working for the government and working in the private sector. This seems biased towards keeping poor people out of politics, but some version of this rule with exceptions carved out for unrelated jobs such as medical practice or teaching would be an improvement on the status quo. Singapore's solution of paying officials very well, just not quite as well as their private sector counterparts, works well in the context of their political system. Mandatory transparency from former officials in their business dealings after leaving office would also improve the situation.

When it comes to getting money out of politics, it's time to admit that the revolving door is a significant problem that requires a systemic solution.

Unassociated Links

1. The Flynn effect has yet to have a significant impact in Liberia.

Exhibit A: The looting of an Ebola quarantine center and the stealing of, among other things, bloody sheets.

Incidentally, the next time we see an article on how average white political science major can't possible do much good over there - remember how irrational and uneducated members of these developing countries can be.

2. Brad DeLong on long run market returns and the cyclically adjusted PE. There are a lot of reasons to be skeptical of the Shiller's CAPE as it applies to predicting future long run equity market returns - it's a relatively unhelpful metric that gets far too much airtime.

3. An example of how not to run a police officer camera program - the SDPD refuses to release camera footage when it matters.

"San Diego police effectively lock any relevant videos in a vault and throw away the public's key. The footage their officers record will never show up on YouTube and go viral. Nor will it help fill in the gaps when a major crime leaves lots of unanswered questions. Crime victims or their families may never get to see and hear what the devices recorded."

It's not just a question of getting police to wear cameras, the policy also has to promote transparency.