Goldman CEO swings for saner pay system - and misses

Yesterday someone asked me what I thought about Goldman Sachs (GS) CEO Lloyd Blankfein's comments on Wall Street pay. My first reaction is that as a fellow who made $43 million in 2008 -- to be fair, Goldman actually made a $2.3 billion profit in 2008 -- Blankfein obviously knows a thing or two about the Wall Street pay envelope.

And he gets points for trying to balance Goldman's interests with those of the public -- but he still missed the mark. I think Wall Street needs its pay in escrow -- if its deals pay off after three years, bankers get the escrow cash; if not, that escrow pays the deals' investors.

Why does Wall Street pay matter?

The answer is simple: People do what they get paid to do. The current system of Wall Street pay encourages bankers to close big deals fast -- the bigger the deals, the higher the banks' fees. And the higher the fees, the fatter the bonus.

What's so bad about that? If those big deals go sour a few years after they've closed, the banker gets to keep the bonus. And if those losses are severe enough -- as they have been in the last 18 months -- the rest of the worlds' governments have to bail out bankers' bad bets to head off global financial Armageddon.

How does Blankfein propose to change these incentives? In his speech, he outlined some important principles:

  • Pay should be granted over a longer period of time;
  • The equity portion of pay should increase as a person rises in the organization -- junior people should get cash, senior people, deferred equity;
  • Individual performance ought to be evaluated based on risk-taking and allow for a clawback effect.

I have mixed feelings about Blankfein's speech. I like the leadership role he's trying to take and his notion that pay should be evaluated based on risk-taking and that there ought to be a clawback mechanism, although I don't know what that would really mean in practice -- for example, if a banker has to give back his or her bonus, who gets the money? The firm or the investors?

But I question whether paying people in equity is a good idea since it has such an unpredictable value. Furthermore, paying people based on perceived risk taking is itself risky. That's because the models that measure risk have proven to be so unreliable -- to wit all those models that predicted mortgage-backed securities loaded with sub-prime mortgages would offer above-average returns with low risk.

Instead of paying people in equity, I would pay them in cash, because cash has a definable value for bankers and for investors. I would put that cash in an escrow account. And I would release the money after three years only if the deals the banker originated remained profitable. If the banker's deals went south, the money would instead be returned to the people who invested in those deals to help compensate them for their losses.

My setup would force bankers to partner with their customers in sharing risks and returns. Such a partnership would force Wall Streeters to be far more careful in assessing the risk and return of the products they pushed out to customers. It would change the very nature of what they produce and make them accountable for their actions.

I believe that my approach to pay is one of six principles we need to adopt to save American capitalism. And it's a really important one.

Peter Cohan is president ofPeter S. Cohan & Associates. He also teaches management at Babson College. His eighth book isYou Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing. He has no financial interest in the securities mentioned.

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