Why Goldman Sachs Should Implement a Clawback Mechanism

Raghuram Rajan attacks banks' compensation systems in the in the FT, to applause from Yves Smith, Alea, and Alexander Campbell. The problem, says Rajan, is that bankers get paid enormous sums of money for generating "fake alpha": profits which will go up in smoke next year and transmogrify into even more enormous losses. Rajan's solution? A clawback mechanism, under which a big bonus would have to be given back in the event that it turned out not to be properly earned.

Justin Fox is dubious:

When times are good, would anybody take a job at a firm with clawbacks built into the compensation plan? That's why this hasn't happened and I can't really see how it will happen unless the market for Wall Street talent totally collapses.

And Andrew Clavell explains in more detail:

A significant reason why the brightest still clamour to sign up at these banks, and why investment bank traders desire to run hedge funds is precisely because their pay is a non-recourse strip of yearly call options on market beta and talent alpha. Come on, we all know this, surely.

I'm a bit more constructive about Rajan's idea. Yes, it goes against the current system, and mercenary traders out for jam today would not want to join a firm with clawbacks. But maybe that's not such a bad thing. And presumably a firm with clawbacks could afford to pay out higher annual bonuses and offer its traders more in the way of job security.

The trick, I think, would be for Goldman Sachs to be the first to implement this system. I can't imagine that Goldman is ever going to have a problem recruiting from Harvard or Insead, as Clavell says would happen to any bank doing this. And so long as Goldman's bonuses keep on rising, its traders - who earn much more than they would anywhere else - are likely to stay.

And once Goldman signed on, it would be much easier for the rest of Wall Street to follow suit.

Over to you, Lloyd.