Bank Compensation and Derivatives

The modern world of derivatives is making it very difficult to regulate business behavior.  Here’s the latest example, reported by the New York Times.

In response to regulatory pressure, many banks have shifted employee compensation more towards stock.  The theory is simple—to align the interests of bank employees with the interests of investors.   If the bank does well, its stock price increases, and the employees make more money.  If the bank does poorly, its stock price falls, and the employees lose money (or, depending on the structure of the plan, at least don’t make any additional money). 

But employees are limiting their risk by hedging, using call options and collars.  These transactions allow bank employees to avoid the downside risk, usually at the cost of giving up some potential upside gain.  Hedging thus allows employees to obtain something that, in terms of risk, looks much more like traditional non-stock compensation.

According to the story, most banks have not yet caught up to what their employees are doing.  Hedging is prohibited by most banks only for executives at the very highest levels.  Of course, banks may not really want to do anything about it, as long as regulators are satisfied. 

-Steve Bradford