President Obama is rightfully committed to strengthening oversight of the financial industry. One of the methods that should be employed is based on the compensation scheme of each company that is being regulated.
It is universally recognized that compensation drives behavior. Any effective oversight must, among other things, focus on what the compensation scheme incentivizes top management and other senior employees to do. Once the behavior is identified, the risks must be identified and evaluated. These risks then must be monitored on an on-going basis.
For simple examples, if an employee is paid hourly, a major risk is that the employee will record hours that were not worked. If an employee has a very low base compensation and is eligible for a large performance based bonus, that employee may take outsized risks to boost the bonus. And if an employee's compensation is based on sales, but not subsequent collections, then the employee may take higher risks on the collection side to make more sales.
Every compensation system can be gamed. No one compensation system is inherently that much better than another. The key is to understand the behavior that is driven by the compensation system. Then evaluate and monitor the risks that have been identified.
Cheers, Mike
Monday, May 4, 2009
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This is a classic Principal/Agent alignment case. I believe that the purpose of an executive leader is to drive long term shareholder value. As such, compensation must be properly aligned with focus on top line revenue growth, bottom line profitability, retained earnings, as well as share price over a set period.
ReplyDeleteStephen, that is a very sound and appropriate goal. On top of that the board should identify the risks that compensation policy drives. In this case, the risk is that earnings are managed or helped to meet share price goals over the set period. I am not saying such executive leader will do anything against the rules, I am saying the board needs to be mindful of the risks, evaluate them and monitor them. Such a compensation risk policy will help reduce the number of "surprises".
ReplyDeleteexcellent point and one that is sorely missed in all the posturing and grandstanding on both sides.
ReplyDeletebut most of those posturing are taking a much different view on how behavior can be manipulated, no?
cheers
Ah yes, manipulating behavior. Takes a lot of effort and rarely works.
ReplyDeleteSeems that the threads on the Chrysler bankruptcy and the threads on compensation can be merged. One focuses on bankers and the other on the new ownership of Chrysler, and soon GM, the autoworkers. However, the same question emerges. How to compensate employees to motivate them to contriubte to the long term success of the enterprise. My bet it is impossible. We have become a society of children that can't see beyond their next paycheck. Good Luck. ;
ReplyDeleteperhaps 'manipulating' was too strong a verb. 'influence' is much more accurate to the point actually. does take much effort (time, $, energy), but might be more effective than one may think, especially when much effort is made.
ReplyDeleteanonymous, for a glimpse at a possibility, check out SEMCO in Brazil.
ReplyDeletewhether it can work in the good ol' USofA is another question of course.
wu ming, what is the SEMCO method?
ReplyDelete