Principal-Agent in the financail industry

Anonymous1987

It seems that the bonus culture in the financial industry might explain some of the poor decision making with regard to over leveraged investments and excessive lending that left many banks exposed in the credit crunch.

I think that a lot of it has to do with the principal agent issue between executives and shareholders. Take for example the age profile of the typical executive level manger i.e. mid fifties/sixties often nearing retirement age. Performance related bonuses focus on relatively short-term profit targets, e.g. quarterly and annual targets. This would lead us to believe that it may be in the managers own interests and career planning to achieve short-term gains for the firm in favour of long-term profitability and sustainability to receive those bonuses. This would also seem to explain the yield chasing behaviour of the financial bubble where "junk status" bonds were bought up, sub prime mortgage lending increased and financial innovation began to hide risk behind increasingly complex derivatives.

The most puzzling element of the bonus culture was as the crisis evolved, bonus's were given to CEO's who were running failing companies. I can't really explain the reasoning for this, maybe the bonus was in return for steering the companies through a tough period which would be a good thing for the long term interests of the firm but it would seem that it was more like a disguised redundancy package as very often these CEO's were later fired.

I'm not sure what can be done about this as it can't really be regulated for and is more likely embedded in corporate culture. It would seem that Greenspans interest rate policy may have been at least partly responsible so maybe this suggests a more sound monetary policy might realign short-term executives interests with long-term shareholders interests. Any thoughts/opinions?

Hasschu

My take on this is that companies with Executives who are grossly overpaid are skating pretty close to the edge of what is legal. To attract a competent executive they have to pay them in advance for up to ten years in jail plus a risk premium since some execs in the US get a life sentence. I am very leery of any company that overpays its executives or sales people, at least I expect to be overcharged and at worst I expect to be scammed. Usually these periods of untrammeled excess end in income tax rates of 85% at the high end as politicians react to public disgust. Of course we are in Ireland, I will stop here here I am on the verge being hard bitten.