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摩根大通交易巨亏折射出的高管薪酬问题
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In The Devil Wears Prada, Meryl Streep's character Miranda Priestly says she lives on hope. I know what she means. But sometimes, I wonder how long we can live that way. We keep paying for the bank's messes. We pay for the government hearings and investigations, the losses in our retirement accounts, the negative impact on the economy, and in many other ways.
J.P. Morgan (JPM) CEO Jamie Dimon testified before the Senate Banking Committee this morning. But in all the hullabaloo and consternation about the bank's oversized bets, only a minute or two was spent on incentives. Sure, J.P. Morgan's proxy has something to say about pay and risk. The company is required to address such things now. And what it says is that "regardless of the motivation," the bank's "risk discipline" and "frequent risk reporting" has "excessive risk-taking" under control. Well, that didn't work so well at Fortune's most admired megabank and No. 22 most admired company in the world.
Despite what Dimon said this morning, it's important to remember this is not an isolated mistake. Bloomberg reported last week that a court appointed monitor is seeking consumer inputrelated to ongoing foreclosure abuses. And the senators at the hearing asked for help for constituents that are being told their paperwork is missing. To his credit, Dimon said the bank would look into the paperwork issues.
But poor oversight is a management and governance deficiency. The billions of dollars in trading losses is merely the most recent example of poor risk oversight at the largest banks
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On May 10, J.P. Morgan disclosed its immense trading losses. But on April 6, a hedge fund manager told the Financial Times: "The thing I'd be questioning, though, is why JPMorgan has such a big directional position when banks aren't supposed to be prop trading any more." And Bloomberg reported on April 9 that "four hedge-fund managers and dealers say the trades are big enough to move indexes and resemble proprietary bets, or wagers made with the bank's own money." If outsiders understood the size of the gambles back then, where were the bank's senior managers and its board? Why on April 13 did they not understand the magnitude, as Dimon testified this morning was the case?
When I speak with board directors, risk managers, and consultants who work with some of the largest banks, they agree that there is still a lot of work to do when it comes to risk oversight. And if Congress wanted to get the real picture, that's who they'd be talking to -- along with other observers who know the score. Not that everyone would be forthcoming, but if Congress asked the right questions, they would get the facts about the bailed out banks soon enough.
Exec pay days, for all the wrong reasons
But let's focus instead on motive and the all too obvious fact: incentives matter. If you pay for the wrong reasons in the wrong form, you'll get the risky behaviors you encourage. We shouldn't be surprised.
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Jamie Dimon became CEO of J.P. Morgan on January 1, 2006. The latest J.P. Morgan proxy shows that Jamie Dimon holds shares (and equivalents) worth over $200 million based on the company's closing price June 8. If the stock price rose to where it was just five years ago, his net worth would jump by $75 million.
A similar pop would net Ina Drew, former chief investment officer at the bank, over $23 million, if you include her deferred compensation and unvested shares. Drew oversaw the unit responsible for the large losses and reported directly to Dimon according to the testimony this morning. As in years past, the board gave Dimon and Drew's pay primarily in stock and options-based awards. Those items alone totaled $17 million and $8.5 million in 2011, respectively.
So what really drives their behavior? And what message is the board sending when they pay their executives this way?
This kind of high pay is exactly what a December New York Fed staff report warned could encourage risky CEO behavior and create economic distress. (Ironically, Dimon sits on the NY Fed's board, although a petition for his removal has garnered over 36,000 signatures.)
In contrast, sound compensation guidance from the regulators recommends risk-based measures, which put a company's and its employees' performance in the context of the quantity and quality of the risk that's taken on. Though banks claim to use risk-based measures, stock price is still the biggest determining factor in top bank executives' actual rewards. But goosing a company's stock price and taking rational risks are not exactly close companions. Former CEO Dick Fuld at Lehman Brothers was the poster child for this issue.
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Even the measures cited in the proxy for rewarding Dimon and Drew are not risk-based. While a spokesperson for Citi (C) (which received a no vote on pay this year) wrote in an email that "Citi has continued to enhance the ability of the firm to reduce risks through its compensation programs," J. P. Morgan, Goldman (GS), Bank of America (BAC), and Morgan Stanley (MS) declined to discuss their pay practices for this article. No wonder. An October 2011 report by the Federal Reserve confirms that the use of risk-based measures at the large banks is "uneven" and every bank has more work to do. "Substantial work remains to be done to achieve consistency and effectiveness … in providing balanced risk-taking incentives," the report states. Put simply, bank boards need a kick in the pants.
Who will step up?
The FDIC put out an advanced notice over two years ago asking for comments on proposing a rule that would charge banks more for depository insurance if their pay programs were risky. Such a measure could have been a real impetus to fix pay. But, "to date, there has been no follow-up to the advance notice of proposed rulemaking," an FDIC spokesperson recently emailed me. And Martin Gruenberg, acting chair of the FDIC, did not address pay or such a proposed rule in his prepared testimony before the Senate last week.
The Office of the Comptroller of the Currency (OCC) is getting beat up these days. They had staff in London where the J.P. Morgan traders were located. An OCC spokesperson explained to me by email that while their staffers review trading data daily or weekly, "even a strong risk management culture could have surprises or breaks, but they should not be of significant magnitude relative to the banks business." Regarding pay, "the [sound compensation] guidance stands as what the examiners are using to supervise banks."
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Last week, in his remarks before the banking committee, OCC head Thomas Curry mentioned"the need to ensure that incentive compensation structures balance risk and financial rewards and are compatible with effective controls and risk management."
Daniel Tarullo testified on behalf of the Board of Governors of the Federal Reserve. But his prepared remarks did not mention compensation. This, despite the fact that the Fed has oversight responsibility for top executives' pay. The Fed's October 2011 report outlines that bank pay "should achieve substantial conformance with the interagency guidance by the end of 2011 (affecting the award of incentive compensation awards for the 2011 performance year), and should fully conform thereafter." Neither the OCC nor Federal Reserve would comment, however, on their examinations and assessments.
The silence, especially from the Fed, is deafening, particularly since the banks' compensation fixes seem to have been done for only some managers rather than the top executives.
But pay programs for top executives matter most because their motives will influence their instructions and other managers' actions. (While the reverse is not necessarily true.)
The October 2011 report by the Federal Reserve states that incentives "were a contributing factor to the financial crisis that began in 2007." The M.O. among do-nothings is that losing billions isn't necessarily concerning for a bank the size of J.P. Morgan. I don't agree. Just because this isn't the 100-year flood doesn't mean we shouldn't repair the levy. How many breaks will we tolerate until we fix it?
Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance (http://thevaluealliance.com), a board advisory firm.
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China and the world of tomorrow
Linda Yueh, currently a visiting professor at London Business School, is a media commentator and contributor to Bloomberg TV News. She is a fellow in economics at Oxford University where she serves as the Director of the China Growth Centre and has spent time as an international corporate lawyer practising in New York, Beijing and Hong Kong.
Her latest book, The Economy of China (Edward Elgar Publishing) was released in May 2010. Stuart Crainer discusses her current research into the developments that have been taking place in China and the pace and impact of what is happening there.
What motivated you to write your latest book?
The Economy of China is basically the story of China and its economic development since 1979, a period in which China became a hallmark in the global economy. Its impressive economic growth propelled it from being one of the poorest countries in the world to becoming its second largest economy, and it did this through an informal transition from a centrally planned to a more market-oriented economy.
My goal was to explain Chinese economic growth by emphasising just how important the role of institutional reform was in its transformation, which meant providing an overview of all the main sectors of the economy and examining each sector by looking at institutional changes, policies and directives from the early stages of the reforms to the challenges of the present day.
You speak of 'institutional reform'. Was that done formally or informally?
Because so many of the institutional changes were rather informal, the Chinese were able to incentivise agricultural output without privatising land, for instance. It wasn't the kind of institutional transformation that you saw in other economies in transition, where privatisation and liberalisation were the norm. Instead, in China the change was gradual.
Basically though, when you look at the reforms still needed if China is to grow into a sustainable major economy, more formal institutional changes will be needed. In other words, while you can incentivise farmers to produce output by giving them returns from their labour, if you want to establish domestic demand and prevent the volatility associated with global exports, you need to make reforms in interest rates, create a social welfare system and allow capital account outflows. And these measures are, by definition, much more formal.
Is it surprising that the starting point for China's transformation was informal?
This is what surprises quite a lot of people because there is a perception that policy and great management are required for the kind of success that China has had, and these factors are definitely part of that success.
I think, however, that what China demonstrates is that if a government sets a permissive regime, a lot of market-driven entrepreneurial activity actually starts from the grassroots. China allowed the market segment to develop, and that was enough to inspire entrepreneurs to begin to develop new industries and create new markets.
Probably one of the more surprising things was the extent to which this informal institutional arrangement gave way to increasingly formal institutional reforms. In the last decade, for example (and for the first time), both a property law, which is an explicit market supporting institution that defines and protects private property rights, and a contract law for individuals were put in place.
Are you saying that turning to Western-type rules was necessary for China to move forward?
Yes, exactly, because one common perception was that there wasn't a rule of law in China so therefore you couldn't have a sustainable market. And while what developed was not a perfect rule of law, quite a lot of the formal institutional protections were extended by the 2000s.
For example, private firms could become limited liability partnerships, and private firms could list on the stock exchange. The proof is in the pudding: those changes have supported productivity growth in China in the past decade that was even higher than what it was in previous decades. In fact, industrial output averaged about 23 per cent in the last decade (per annum, in real terms), but it was only half that in the 1980s and 1990s when Chinese growth already was robust.
Can these rates of growth continue? And, if so, for how long?
I think China is facing many challenges. It has to move toward a market much more clearly defined by formal, legal and regulatory institutional structures because it is such an important, globally integrated economy. And, if it's able to do that, then it has the potential of transforming itself from what it is currently, which is a lower middle-income country, to an upper-middle-income country over the next decade or so.
At the same time, it is important to be aware that once an economy hits this middle-income threshold, its growth rate slows because the initial catch-up phase ends. For instance, if you want productivity to increase (which has to sustain the next stage of growth), you have to protect innovation, and that implies much better intellectual property rights protection.
In other words, they need to build the institutions of capitalism more rigorously?
Yes, absolutely. I think they have to pay more attention to what we in the West take for granted as supporting the market in advanced economies — transparent regulation, effective rule of law, efficient dispute resolution and security of transactions.
This is not an uncommon step for developing countries. It's just that China had institutions dominated by the state, just like the former Soviet Union had; and those institutions had to be gradually dismantled while at the same time China had to incentivise the usual development processes as well.
Comparisons of China are regularly made to India and Russia, two other large countries experiencing enormous change. Are these comparisons worthwhile?
When it comes to Russia, the comparison to the replacement of communism by capitalism is interesting because when communism fell in Russia in 1989, it was quickly replaced by the privatisation of all state-owned industries. The change in China, as I mentioned earlier, was an informal, slow process — and it began a decade earlier.
The similarity to India lies mainly in the fact that they're both such big countries — over one billion people; but it is important to keep in mind that there are many differences between the two. The main one is that China has had to gradually dismantle state-owned enterprises, which is very different than the challenges that India faced when it began its upward path after gaining independence from Great Britain.
How would you describe the Indian economy then?
The Indian economy has seemingly turned a corner, which can be dated to a move towards embracing greater global integration. For example, it joined the World Trade Organisation when it formed in 1995, which enabled it to integrate its services sector and that has helped to diversify the Indian economy. As a result, Indian growth, at the moment, is approaching Chinese rates, growing 8.8 per cent in the second quarter, which is substantially higher than the 6 per cent it grew at over the previous 15 years or so.
But whether or not that's sustainable depends a great deal on its ability to continue diversification — that is, can India sustain a bigger industrial sector and a more diversified services sector which create jobs?
To do that, India will require some very difficult reforms involving boosting human capital, such as improving the educational system. Thus, while India has tremendous potential, it also faces the enormous challenge of industrialising sufficiently to create employment.
The key point is that India still hasn't developed a reasonably skilled, large labour force the way China has; and without that, it's hard to industrialise. While industry is a relatively small share of GDP relative to services and agriculture, a country needs to it create a wider base of jobs. If a country doesn't create jobs, people have no incentive to go and acquire education in order to get a job. It's quite a chicken and egg problem.
How much time do you spend in China and is it just for research?
I visit quite often; for example, I was there in January 2010 working on giving advice on the country's 12th Five Year Plan, and I was there the following May and June for conferences debating how China can rebalance its economy.
So you advise the government?
Not directly, but it was perhaps the first international seminar the Chinese government's top policy body had ever held on the Five Year Plans, and they invited three international experts to give them advice on the 12th Five Year Plan. I was one of them.
How do you assess China's future?
I'm optimistic, but cautious. That's because I see a number of significant downside risks. After all, so much of Chinese growth has occurred within this very complicated context of state ownership with quite a lot of restrictions on the free market — restrictions on everything from its banking system to managing the business cycles to the ability to meet the expectations of foreign investors.
All these factors give me some cause for concern. So, I see China's underlying fundamental growth potential to be very positive, but I also see the number of challenges that it faces as it tries to lift average incomes significantly above $3,000 per capita, which is what it is at the moment.
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