Performance-based remuneration

Remuneration policies of financial institutions have become more performance-based, with larger components of variable salary. Figure 3.6 shows the increase in Wall Street bonuses since the 1980s. Deregulation and increased competition have been important factors behind the development of rewarding CEO’s with stock options. Philippon and Reshef (2009) find that

deregulation accounts for 83% of changes in the relative compensation of the US financial sector with respect to the rest of the non-farm private sector from 1909 to 2006. Cunat and Guadalupe (2009) argue that deregulation and increased competition in the nineties triggered an increase in the variable component.

Figure 3.6 Growth Wall Street bonuses (Source: Office of the State Comptroler, New York, January 2009)

0 5 10 15 20 25 30 35 40

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Bonuses (billions of dollars)

John and Qian (2003) study the distribution of direct compensation from 1992-2000. They identify three noteworthy aspects. First, total direct compensation increases over the years.

Second, option grants as a fraction of the level of salary also increased. In fact, the percentage of option grants in direct compensation has increased from 20 percent in 1992 to 54 percent in 2000. Third, both the increase in total direct compensation and the increase in the number of option grants do not seem to be strongly correlated with stock performance.

Amendments in tax and accounting rules may have contributed to the increase in variable incentive-related compensation. In particular the US congress passed an Omnibus Budget Reconciliation Act that did not allow to deduct non-performance related compensation of managers in excess of 1$ million dollars for corporate tax income. The purpose of this Act was to diminish excessive CEO salary levels. In response to this Act many companies increased their cash allowances to below the threshold of 1 million dollars and began to add option grants to restore de facto the tax deductibility.

4 Scenarios

In this chapter, which forms the core of our study together with chapter 5, we develop four scenarios for the financial sector to provide insights in possible future developments in the financial sector. The main questions in this section are twofold. First, what future scenarios do we foresee? Second, how does a particular scenario affect market structure, market failures, and government failures discussed in section 2?

Section 3 provided insights in the main drivers behind past developments in the financial sector. We argued that developments in information and communication technology were the main factor driving developments in the financial sector. Also after the crisis, ICT will remain the driving factor behind our scenarios. Technological development affects economies of scope, the contractibility of transactions and the asymmetric information between buyers and sellers in financial markets. As we will argue in more detail below, the direction in which ICT influences these elements is not clear.

Our scenarios are a tool to analyse the effectiveness of different policies. In some scenarios, policy makers have a different toolkit than in others, while even if the same type of policies are useful, priorities might differ. In section 5, we will discuss the various challenges faced by policymakers.

Any scenario study should be clear about its limitations. Our scenarios do not describe all possible futures, but focus on a subset that aims to identify the main uncertainties relevant for policymakers. In addition, we do not give a detailed picture of those futures selected. Instead, we paint a broad-brush picture of each scenario, focusing on market structure, the effect on market failures, and the consequences for government failure. Also, we do not consider one scenario to be more likely than another. All scenarios can materialise and we have no view on how probable each scenario is.

Finally, and most importantly, our scenarios arise through developments that policymakers cannot influence. In terms of this study, policymakers are not able to choose how important markets are relative to financial intermediation, whether banks add value by monitoring their clients or by generating soft information, and whether economies of scope are important or not.

Instead, one day they will have to act in a certain scenario to increase welfare by reducing market failures and government failures. Nevertheless, in each of our scenarios, policymakers can influence the structure of the financial sector. For example, banks’ size or banks’ scope can be limited by limiting the size of banks’ balance sheets or the type of services banks are allowed to provide. However, the costs and benefits of such policy measures depend on the scenario that materialises.

An analogy may help to clarify this point. Our four scenarios can be compared to four different landscapes, and the policymaker with a traveller who, being located at some particular point, wants to decide where to go and how to travel. The traveller cannot choose which landscape to travel in. Instead, the landscape exogenously arises. Whether the landscape is

mountainous, has large forests, or deep rivers determines the time it takes to travel from one place to another. Of course, our traveller can a go to any particular point independent of what landscape materialises. But where a policymaker would want to travel, how he would travel and how long it would takes to get there, differs between different landscapes.