Saturday, March 21, 2009

The Social Insurance of Private Risk: Executive Compensation and the Merits of Government Intervention

The ire for Wall Street that has been the hallmark of anti-globalisation activists has become mainstream as evidenced by the notorious name recall of such entities like AIG and Pac Brands in Australia. The legitimacy of government bailouts for firms that have turned around and paid their senior executives hefty bonuses has been called into question. Legislators and responsible governments that approved such dole outs have scorned these practices citing the fact that the social insurance of private risk-taking has occurred.

They have not realised that it was government policy that set them on this course to begin with by encouraging such dubious lending practices in the housing market to the so called ninjas ("no income, no job, no assets"). AIG merely sought to manage away such risks through credit swaps and other financial derivatives. The lack of oversight into these contracts did not help them hold back when times were good.

System dynamics heralded as the science of unintended consequences tells us that when prolonged feedback loops are present policymakers will often fail to connect the dots that link their actions with such perverse outcomes. They may instead associate adverse consequences with near-term causes (in this case "greed") and formulate their responses based on them.

Insuring executives against risk is not a bad practice per se. In fact, it is desireable to some extent. To use a sports analogy, every club guarantees its "star players" an incentive to "go for it" in the field, even though they risk injury that could jeopardise the rest of their careers in the process. What would happen if a player "held back" at crucial moments in a championship match for this very reason? Salaries remain fixed whether the player is fit for the entire season and are not dependent on the team winning the tournament (although renewal of contracts might).

In the case of David Beckham, when he transferred to the LA Galaxy franchise, his prominence allowed them to maximise receipts from footbal matches held at their stadium. This alone made his outrageous salary worth every penny. For the same reason, some executives may focus on generating short-term growth in market share or profits to the detriment of long-term sustainability.

David Beckham's outrageous salary was worth every penny for LA Galaxy.

But even if their remuneration were based on some long-term metric such as growth of value in the company's stock, there would be no reason for the firm to stick to the contract once it has established that an executive decision (say outsourcing of production overseas) sets the firm on good financial footing. Some savings may in fact be derived by paying him out if he is nearing retirement (could this be the case with Pacific Brands?) and makes the setting of executive pay a tricky business because a long-term contract merely becomes the starting point for renegotiation later.

On the one hand, if they are not insured against failure, CEOs may become too averse at taking investment decisions if there is a possibility for large losses. On the other hand, critics have turned to the mechanisms for setting pay and the way it can be captured by corporate executives.

Board members who are meant to be independent in making decisions covering this area often share an affinity with their Chief Executives by virtue of having been nominated by him (or her) in the first place. So called compensation experts suffer the same fate as external auditors, often screened by CEOs before getting hired by the board. The difficulty here is in designing good corporate governance practices to avoid these forms of capture.

In the end, if the attainment of desirable social ends, such as a more equitable distribution of property or the protection of jobs in an uncompetitive industry, was offered in promoting risky projects in the private sector, society should not balk at insuring these social experiments from failure. The problem is that when these programs were formulated, they may have been designed with an eye at preserving the short-term electability of a politician, but that merely leaves us where this discussion began.

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