The following comes to us from Felix Zhiyu Feng, a PhD candidate from the department of economics at Duke University

The lucrative compensation of Wall Street bankers and executives has always been an issue of media interest and public concern. It is also at the center of studies on corporate governance, which tend to question its legitimacy, especially when firm performance is poor. When it was revealed that during the recent financial crises, despite huge profit losses, Wall Street bankers and executives still took away over a billion dollars of cash bonuses, not surprisingly there was immediate outrage from the general public to our top politicians. President Obama condemned the bonuses as being “shameful” and pledged to take actions against them.

For obvious reasons, large bonuses during bad times are controversial. The widespread belief is that they must be a sign of managerial entrenchment and suboptimal contract design. Subsequent policy changes recommended by both policymakers and scholars are largely based on this premise. Admittedly, our current compensation structure is far from perfect. Nevertheless, we should examine carefully any suggested alternatives.

In my paper Uncertainty Shocks and Dynamic Compensation Under Limited Commitment, I propose a theory which argues that large bonuses during crises can be the result of an optimally designed contract, if we relax the strong assumption that firms can always credibly pledge future payments to their managers. Standard research on contract design usually assumes that firms have full ability to commit to compensation contracts. In particular, it usually defines an explicit terminal point, the reaching of which results in certain contract termination. It is a handy assumption for preliminary analysis but far from being precise in practice, where commitment to future payment is generally difficult. At-will employment is by and large common practice in the US. It is not surprising for even highly ranked executives of big firms to walk into the office one morning only to be informed that they are no longer needed. Firm liquidation is another way in which employee contracts can be abruptly terminated. While laws exist to protect employees’ earned compensation, it is virtually impossible to seek reimbursement for any future compensation in the event of contract termination, due to either turnover or liquidation. As individuals are forward-looking, the valuation of any compensation contract depends on how much future payments the contract can actually deliver. As such, managers are concerned about future job security and future income and will therefore take these into consideration before agreeing to any contract.

Firms’ inability to credibly pledge future payments limits their ability in using long-term compensation as a means of managerial incentive provision. Taking into account firms’ likelihood of default, managers prefer front-loaded compensation. During crisis times when firm value is low and future uncertainty high, deferred compensation is even less credible. During hard times, firms may prefer postponing compensation to managers but their ability to credibly promise future compensation is limited. In order to retain managers who perceive shorter contract length due to adverse firm conditions, firms must substitute future payments with more immediate payments.

The finding that large bonuses can arise from firms’ inability to fully commit to compensation contracts serves as a caveat to policymakers. In the aftermath of the recent financial crisis, there have been several proposals to compensate managers via more deferred means in order to better align managerial interests with those of shareholders. However, deferring compensation implies less value in the future for shareholders, who will be more tempted to sell their shares, raising the likelihood of firm liquidation even higher in crisis times. Managers, anticipating this, will demand even more immediate compensation since shareholders generally cannot commit not to sell shares.

The story does not end here. It is critical to design compensation contracts properly because managers must be incentivized to exert maximal effort. When the benefit from providing incentive is sufficiently low, as can be the case during crisis times, firms could find themselves better off by simply allowing managers to shirk or “enjoy a quiet life”.  Since shirking has its own value to managers, tolerance for shirking can be a substitute for wage compensation, but it comes with a cost of lower firm productivity. In other words, granting bonuses and allowing shirking will keep managers around, but only the former will keep them working. Therefore, little or no bonuses observed during crises, although more agreeable to public sentiment, could suggest a worse economy than the one in which bonuses are observed, as average productivity of the entire economy could be lower.

In short, pay-for-performance does not tell the whole compensation story. During crises when firm performance is poor, withholding compensation from managers could result in further deterioration of performance, leading to an overall weaker economy. While not ruling out the possibility of “fat-cat” bankers drawing large bonuses from taxpayers’ money intended toward bailing out firms for the purpose of stabilizing the economy, I do caution against rushing into policy-making only to realize ex post how a policy can backfire.

The complete version of this paper is available here.