Tuesday, 7 April 2009

The Financial Illiteracy of Lloyd Blankfein

I listened to Lloyd Blankfein tell the Council of Institutional Investors today that compensation in the banking industry should contain a significant element of deferred compensation in the form of restricted stock in order to limit 'excessive' risk-taking by employees. I have three problems with Blankfein's suggestion.

First, Blankfein's recommendation would result in employees increasing their exposure to their employer. Not only would their employment be subject to the fortunes of the firm, but their investment holdings would be strongly correlated with the fortunes of the firm as well. If Blankfein provided this sort of financial advice to a private wealth client, he could be sued for abrogating his fiduciary responsibilities.

Second, the equity of the bank can be viewed as a call option on the net asset value of the bank. As such, its value is an increasing function of the volatility of this net asset value. Anyone who wants to increase the value of this stock has an incentive to increase the volatility of the net asset value of the bank. This is particularly true when the value of the equity is low relative to the net asset value of the firm, as is the case presently. If Blankfein really wanted to restrict the incentive for employees to take 'excessive' risks, he would prohibit employees from owning stock in the bank rather than requiring that they do so.

Third, employees will only be indifferent between being paid in cash and being paid in restricted stock of their employer in the event that the restricted stock is provided at a significant discount, in order to reflect their increased risk exposure to their employer and to compensate them for the restricted nature of the stock. Inevitably, this discount will be paid by the employer. As a practical matter, do the shareholders really want to be selling significantly discounted shares to anyone, including their employees?

By paying all compensation simply as cash, Blankfein would mitigate employee incentives for taking 'excessive' risks and reduce the labor cost paid by shareholders. I only hope his misguided recommendations are a bow toward political expediency in the current populist environment rather than a display of genuine financial illiteracy.

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