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Is Compensation a Villain Of the Credit Crisis is the title of a recent post on the US Banker website.

“While compensation was not THE cause of the current credit crises it certainly can be viewed as a significant contributor.”

The idea is that today, bank’s incentive compensation plans are mostly based on the current year’s revenues.  However, most trading profits are from revenue streams spanning multiple years.

The authors recommendation is to audit incentive plans to identify and remove features that incent short-term behavior.  He also makes several other recommendations including:

1. Executives should have significant personal capital at risk
2. Current cash and long-term reinvestment in the firm should match the firms’ lines of businesses generating its profit
3. Take back incentives if deals do not go through (only incent when actual profit is made)
4. Ensure executives understand and take risk ownership
5. Measure performance for the entire firm
6. Develop talent from within and build a long-term culture.

Not bad ideas, but I’m sure financial institutions have many very smart people considering this as well.

When I read this article, I was wondering, could compensation really have a significant role in the credit crisis?

Investment bankers earn a lot of money…  A lot of people in the financial sector receive (received?) huge bonuses.  But let’s take for example Lehman Brothers.  In 2006, along with many other investment banks, Lehman Brothers had a stellar year: it paid its average employee $335,441 and reported a fourth-quarter profit of 1 billion.   This is after of course, paying 8.87 billion in salary to its 26,000 employees.  Goldman Sachs has even more ridiculous figures; it paid its 26,400 staff an average of $622,000.  Two years later, Lehman files for bankruptcy.

So, how much can we blame “crazy” compensation versus bad risk management?  I’m not a financial analyst, and I’m not pretending to understand the entire issue…  However it seems logical that a firm such as Goldman Sachs, who paid almost twice as much in average compensation in 2006, should be hit equally hard by the credit crisis as another firm such as Lehman Brothers, if compensation was such a major factor.

Goldman Sachs Performance

It turns out that while Goldman Sachs was affected by the credit crisis, it is not in such a bad shape…  despite having paid its employees more.  And this proves that…  the credit crisis is a very complex problem, and that maybe, maybe compensation is not such a “significant” contributor to the credit crisis.