30 September 2009

A Proper Measure Of Excessive Bank Exec Pay

Everyone loves to hate huge paychecks for big business executives. But, outrage simply because executives of big businesses make very large sums of money isn't justified when those big businesses are profitable. Excessive senior executive pay is primarily a fight between shareholders and management over claims to the profits generated by everyone below them in the organization. If senior business executive pay packages are modest relative to the returns that the companies provide to shareholders, this isn't a cause for concern. The people whose compensation finances high senior executive compensation are being taken care over nicely.

But, these days, executive pay has gotten to a level where it is a concern to shareholders. Executives are getting paid well even when they aren't producing good returns. In the fight between shareholders and management over the money generated by big businesses, bank executives are winning. They are running their companies as if they were senior executive owned closely held businesses, taking home more than 80% of the distributed returns of the banks.

In 2008, salaries of the top 10 banks reached $75 billion (up from $31 billion in 1999), while cash dividends to shareholders were only $17.5 billion. Management took 4.3 times more than shareholders at a time when shareholders were injecting capital and government was guaranteeing deposits.

Capital has never been more important to banks, but the rewards are going to the executives who have screwed up the American financial system, not to the people providing capital. Indeed, bank executive bonuses are at a level on the same order of magnitude as the $69 billion of capital that the "stress tests" conducted in 2009 showed that these banks need to avoid collapsing in the event of bad economic news.

When management is getting more than 80% of the paid out returns from the enterprise, it is time to worry that the system is fundamentally flawed.

Private equity funds and hedge funds, in contrast, are designed to have the opposite ratio of capital return to management return in most cases:

[I]nvestors typically pay 2% of committed capital to the management company to manage the fund and 20% of returned funds above the initial capital as an incentive.

The management fee is fixed and agreed upon up front. The 20% of returned funds above initial capital, called the carried interest, is typically paid to investor and management alike five years out or so, and leaves the investor with 98% of what they invested, plus 80% of the profits.

For a private equity firm as a whole to get at least 81% of returns bank executives received under a 2/20 compensation formula, it need to be earning a roughly 3.3% or less investment return over the entire term of the investment, which is a little more than six-tenths of a percent per year in a typical five year deal.

In reality, since a good share of the 2% management fee goes towards overhead and salaried employee costs similar to the expenses of ordinary banks on their overhead and salaried employees. Overhead is a lot smaller in a private equity fund than it is in a commercial bank, but everybody has to pay some rent and make payroll for the staff. My very rough estimate is that overhead and salaries eat up at least half of the management fees in private equity funds. This implies that the senior management of a private equity fund gets an 81% of the returns only when the fund is producing an annual rate of return of about three tens of a percent per year, the same rate of return that my bank pays on plain old FDIC insured savings accounts, or less.

Needless to say, unlike senior bank executives, private equity fund managers who have trouble generating FDIC insured savings account returns to their investors rarely manage to keep their jobs.

The obvious conclusion: While the mere fact that bank executives get large pay packages doesn't itself prove that they are overpaid, other measures of their pay that are reasonable and proportional do show that bank executives are getting too large a piece of the pie.

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