Clawbacks a step in the right direction

Long have I decried that financial industry employees, especially its executives, are improperly compensated. Specifically the employees typically are incentivized in such a way that they can only breakeven or gain huge amounts of money. Very rarely are they punished for very poor, unnecessarily risky choices. Not only that, but the time scale is all screwed up. What good is it for shareholders if for four years in a row the employee does screamingly well but in the fifth year those choices absolutely tank, losing most of their value? That is exactly what a clawback provision is designed to address.

Under pressure from shareholders many of the major financial institutions are now putting in clawback provisions in their compensation award structures. This is an excellent step forward. Unfortunately, there is still more to do. Specifically I am thinking of the fact that the best of these clawbacks has a three year time horizon in mind. While this certainly beats the quarterly or annual structure that has been in place, the fact is that investments made by a financial institutions traders have longer term effects on the company than 3 years. So what do I propose? I propose that traders at financial institutions be made to declare the time horizon over which they feel an investment ought to be evaluated. That way compensation is in alignment with their thinking. You might think that a trader would then declare a short time horizon in order to be rewarded – but the fact is that some of these investments take years to come to ultimate fruition. One way to handle this is to set up a system that includes language like “the longer of either 3 years or the declared length of time as stated by the trader will be used in evaluating the success of an investment.”

Another problem is at what point are the clawbacks triggered? In other words, how much has to be lost and over what time period. Say the clawback is triggered after a 30% decline. What happens if the day after the value of the trader’s investment has dropped 30% it then increases in value so that it is back over the 30% drop threshold? These are technical questions that involve quite a lot of art. The important point is that clawbacks put more of the trader’s skin in the game; and this is a good thing. We want people making multi-million and billion dollar decisions to be thinking about the long-term ramifications of their choices. Amen!

Jason