Wall Street's Misaligned Incentives

To The Editors, Wall Street Journal:

Jonathan Macey (“’Say on Pay’ and Other Bad Ideas”) argues that “new federal regulations on compensation attempt to obtain by bureaucratic fiat results that the markets and ordinary democratic processes rejected.” I would argue that Wall Street’s “market driven” compensation practices, which all too frequently misalign incentives, are one of the core problems behind the meltdown.

Markets only work when participants’ financial incentives motivate them to “do the right thing.” In today’s complex markets (unlike Adam Smith’s simpler times) it is extremely difficult to design appropriate financial incentives – just ask any board member who sits on a compensation committee. All too often the financial incentives focus participants on short-term results, to the detriment of the long term, since we imperfect humans understand the short term much better. It is an expensive expedient.

Participants in our financial markets are largely motivated by quarterly and annual transaction performance, even when 30-year mortgages, permanent acquisitions or company-risking derivatives are the transactions in question. This is gross market failure, and we are all paying the consequences. While I’m not sanguine about Washington doing a better job, it is Wall Street’s failure to get it right that has stirred the beast into action.