The Root of All Evil

Defanging the bonus system without ruining Wall Street

Preet Bhahara, the U.S. attorney whose office convicted Rajat Gupta, Raj Rajaratnam and 62 others for insider trading, recently told a hedge fund audience that these cases have given the public “more confidence in the market.”

I’d say just the opposite.

What Bhahara’s successful prosecutions have shown is that the financial markets are teeming with scofflaws, and the cheaters who have been caught thusfar may just be less clever than those yet to be unmasked.

Even seasoned Wall Streeters must admit that the amount of corruption being uncovered in the financial services industry today is nothing short of astounding. The widening LIBOR scandal is the coup de grâce, given its vast financial scope and potential implication of national governments.

Why the rampant criminality? There’s no question that the obscene sums paid out as compensation today are temptation enough. At the very least, financial professionals – like other businessmen – measure themselves by what they earn, and they earn more if they are better, faster or smarter than their competition. To someone who trades tens of millions of dollars a day, and earns daily profits in the millions, what’s a $10 million annual paycheck? A day’s work.

Both here and in the EU, regulators seem to be focused on restructuring the bonus system to root out would-be miscreants. The way Wall Street pays its investment bankers, asset managers and traders — through bonuses in exchange for production – is now seen to promote short-term decision-making, encourage excessive risk-taking and ultimately lead (apparently too commonly) to felonies. To be sure, under the current system, Wall Streeters are playing only for upside since their pay packages carry no downside risk.

Restructuring bonuses, however, gives rise to two potential hazards. Eliminating, capping, deferring or clawing back bonuses will simply increase the fixed cost of attracting or retaining top talent, a hallmark of the investment banking and management industries. In addition, Wall Street has earned a well-deserved reputation for dodging unwelcome regulations, either through gaming or arbitrage. The same cunning would undoubtedly be applied to bonuses awarded in the form of fund units or equity-linked instruments that can only be monetized under limited circumstances. Though any of these measures could dampen the industry’s enthusiasm for risk, none seems invasive enough by itself to truly excavate venality from our current financial culture.

The best idea I’ve heard to date came from an FT article last week suggesting that investment banks be forced to go back to where they began, as general partnerships in which the executives are personally liable for any losses suffered by their firms. If that were the case, I would think that even the most aggressive financial professionals would think twice before exposing their firms (and clients) to investment risks they would not take themselves.

To that suggestion I would (self-servingly) add that another way to make sure that every financial firm watches its p’s & q’s would be to have a respected lawyer present in every meeting of its management committee or board.