How should financial institutions compensate their employees? A complicated question for the owners, and their ‘agents,’ meaning boards and compensation committees. Economic theory is not very helpful because it is based on optimal contracting and the answer very much depends on the what is known or knowable about the manager or pool of possible managers. Empirical evidence is also sketchy. But the financial crisis speaks clearly — we want to avoid the situation in which an informed financial institutions makes money by selling out of the money puts. This is like selling insurance against rare correlated or macro events and not keeping a reserve to pay out when the event occurs. For example, insuring MBS, booking profits and bonuses in the goods times, and failing spectacularly in the bad (hello AIG and, through off-balance sheet holdings, Lehman).
The government agencies have now weighed in. The Fed, the OCC, OTS, and the FDIC have issued guidelines for compensation practices. From the document, the key principles of good practice are:
“. . . (1) incentive compensation arrangements at a banking organization should provide employees incentives that appropriately balance risk and financial results in a manner that does not encourage employees to expose their organizations to imprudent risk; (2) these arrangements should be compatible with effective controls and risk-management; and (3) these arrangements should be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.”