The Hindu Business Line : Escrow no go

If you were an investment banker, PE fund employee or any such ‘bonus drawing’ type player of the financial and capital markets, I have a very scary word that a lot of people seem to be talking about suddenly.

Clawbacks. Ever heard of it? If not, then pray that you and the people at your firm who make calls on your bonus, in particular, and your remuneration, in general, never do. A number of voices, none of them bankers surely, on Wall Street are asking for ‘clawbacks’ to be implemented into bank bonus policies. This debate makes particular sense in the light of the current banking news and a recent newspaper article by Raghuram Rajan.

Massive write-downs

As of writing this column, Citibank has declared massive write-downs totalling over $18 billion due to setbacks from, no prizes for guessing, the sub-prime debacle. This is the latest in a season of terrible bad news from all the major names on Wall Street.

Over the latter six months of 2007, most of the top banks, save Goldman Sachs, have reported huge losses. So one would expect the banks to act all responsible and be frugal with their bonuses, right? Try to use some of the money to strengthen that balance-sheet perhaps. Make sure that largesse does not come at the cost of an over-due reality check.

Well you would be surprised at how optimistic, or dumb, Wall Street is. Bloomberg reported on January 17 that the banks will dole out some $39 billion this year. For those not in the know, this is actually higher than the amount of total bonuses paid out for 2006, be it by a small margin of three billion big ones.

Simply greed

At first glance, this sounds absolutely atrocious. In a year when banks have made billions in losses, and shareholders have lost multiples of those numbers in bruised portfolios, why do banks keep paying such hefty numbers?

The simplest answer is greed. Wall Street has never been known for restraint when it came to compensation. And, perhaps, one little sub-prime booboo isn’t going to change years of fat envelopes and a pat on the back.

If this is so, then this is undeniable largesse in these trying times. Now, more than ever, many people argue, was a time for the banks to hunker down and prepare to battle through a period of lasting financial uncertainty.

The voices that are speaking of an impending recession in the US, with global implications, increase in number and volume on a daily basis. Oil prices are high as well. Yet, if the banks think that bonuses are sacrosanct, perhaps we don’t see something they do.

On the other hand, there is a reasonably valid viewpoint that, in the light of impending struggle, the banks need to hold on to their best people at any cost. So while there are jobs being chopped off — Citi is shedding some 4,000 — the ones left are being paid big money to ensure they stay.

(Which begs the question: Someone is going to poach them in this market? Seriously?)

And into the midst of this discussion, which you will hear more of in the weeks to come I am sure, a nice little firecracker was thrown in by Rajan’s article in the Financial Times.

Clawback bonuses

He talks about the increased total bonus payout for 2007: “…most readers would suspect something is not right here.

Indeed, compensation practices in the financial sector are deeply flawed and probably contributed to the ongoing crisis.”

Rajan goes on to say that companies must clawback bonuses from people whose performances in the previous years led to the gloom and doom today. (As surely traders in sub-primes must have cashed in big time in the years just past.)

He even suggests that banks hold bonuses of traders in escrow till such period that the entire risk inherent in their trades has completely played out.

Rajan sees this as a way of preventing traders and their ilk making tremendous short-term gains on strategies that are destructive in the long term.

Otherwise, as we have just seen, where is the disincentive for people who took bad calls on sub-prime to sober up if they make even more money this year?

A quick scan of responses to Rajan’s piece reveals that most people see the merits of what he’s trying to do. But many think it’s not practical in today’s market for talent and profits.

Food for thought

Who’d join a company which had a clawback clause built into its policy? Especially when banks are still hungry for fiery traders who will leave no derivative un-used in the mad run for profits. And which bank, honestly speaking, can tell its employees to look at long-term risk implication and sacrifice lucrative short-term profits?

So while Rajan’s advice seems to have fallen on mildly deaf ears it gives all of us in the rapidly developing Indian scenario food for thought.

How do you balance the risk-return equation on the trading floor? How do you set the right incentives to prevent a sub-prime-esque fiasco?

Perhaps, my mind tells me, we have not heard the last of ‘clawback’ and Rajan’s ‘escrow bonus’ yet.

(The writer, an alumnus of IIM-A, was a management consultant before quitting to work on a book and a full-time writing career)

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