Big bonuses on Wall Street mean big risks

Eduardo Munoz / Reuters

JPMorgan, the largest U.S. bank by assets, said a botched trade in its London office has cost the company $5.8 billion.

By Roland Jones

With banks and brokers under fire for everything from rate-rigging to multibillion-dollar trading losses, observers are beginning to ask if the pay structures on Wall Street are to blame for the current rash of financial wrongdoings.

Last week JPMorgan, the largest U.S. bank by assets, said a botched trade in its London office has cost the company $5.8 billion, with another $1.7 billion in losses possible as it works to ?unwind? the failed trade.

And in late June Barclays paid $453 million to regulators in the U.K and the U.S. to settle accusations that it had tried to influence a benchmark interest rate that affects the price at which consumers and companies across the world borrow funds.

The rate-rigging scandal at Barclays is expected to involve other big global banks and be one of the largest to hit the banking sector since the financial crisis.

Yet little has been done to tackle the incentive problems at big U.S. banks since the crisis struck four years ago, said Paul Hodgson, a senior research associate at GMI Ratings, a company that analyzes publicly traded corporations.

Hodgson told CNBC his research shows the incentive structure on Wall Street, in which bonuses are paid based on short-term profits, was one of the prime factors that caused the financial crisis in 2008 and 2009.

The structure has traditionally encouraged employees to act like gamblers at a casino, taking big risks, and after the crisis big banks continued to hand out big bonuses even after they had to be buttressed with billions of dollars of taxpayers? money.

There have been some changes to the compensation structure at banks since the crisis, but most of them have taken place in Europe, Hodgson said. The behavior at JPMorgan, where one trader made very risky bets, was not covered by recent changes, which mostly affect senior executives, he added, noting that the significant changes made to banks in Europe ?haven?t been spread far down the organization in the U.S. yet.?

Incentives need to be tied to long-term performance, said Hodgson. Pay should be put at risk over the long term, so if an employee engages in a trade or a deal that doesn?t pay off there?s a possibility that the worker will lose his or her bonus, he said.

Wall Street?s current bonus system is a relic from the days when banks were private partnerships and each year those partners took a percentage of the profits as compensation. When banks began to become public companies in the 1970s and 1980s partners? capital was replaced by shareholder money, but the banks held on to the bonus structure.

?Banks started using less of their own money and more of other people?s money,? and the banks? balance sheets, and their risk-taking, grew over time, said Charles J. Murphy, a professor of management practice at New York University?s Stern School of Business.

?It?s a lot easier to lose someone else?s money than to lose your own,? Murphy said. Under that scenario, you?re more likely to go for a home run than a single, he added.

Murphy also said the planned ?clawback? of millions of dollars in bonuses from executives and employees at JPMorgan?involved in the bank's misguided trading strategy could go a long way toward changing attitudes on Wall Street. JPMorgan is one of the first major investment banks to disclose such a high profile clawback.

If an employee realizes he or she has to give back some of that money in the future ?it will have a strong psychological effect? on others at the company and the industry more broadly, he said.

Don Delves, a consultant on corporate governance and executive pay, said it?s not necessarily the incentive?structures on Wall Street that are to blame for excessive risk. Instead, there?s a need for proper oversight of the risks that people are taking.

?There?s no question that the bonuses and the bonus systems cause people to take risks -- that?s what there?re designed for. They?re designed to encourage workers to make a lot of money for the bank, so they make a lot of money for themselves,? he told CNBC.

?The incentives have caused people to be very creative and think up all kinds of creative new products, but that creativity needs some kind of oversight,? he continued. ?You need people who are just as smart as the guys making the trades to make sure they are not taking inappropriate oversized risks, which obviously happened here.?

Still, many who work on Wall Street are motivated by more than money, said Constance Melrose, managing director of eFinancialCareers North America.?In surveys of job candidates she finds many are concerned about making a positive impact on their clients? financial lives, or helping corporate clients to grow their business.

?There is a large cadre of people in financial services sector who do think can make an impact and want the industry to manage itself better from a risk perspective and customer service perspective,? he said.

Discussing whether the bonus system is responsible for these huge bets and often huge losses, with Donald Delves, The Delves Group, and Paul Hodgson, GMI Ratings.

Source: http://marketday.msnbc.msn.com/_news/2012/07/18/12793197-big-bonuses-seen-leading-to-current-wall-street-scandals?lite

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