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June 01, 2011
Tail risk and Compensation in the Financial Sector
Post the North Atlantic Financial Crisis of 2007-08 there has been an increased emphasis on deferred compensation and stock compensation. Is this meaningful?
See "Bad bonus rules are worse than bad bonuses" (The Economist, 5th January 2011) for an interesting analysis on regulating the compensation structure.
Here is different proposal : Traders, risk managers and top management (including non-executive directors) ought to bear some tail-risk...Let me explain. If a trader earns an income of US$ 100,000 and bonus of US$ 400,000 then in that year the trader shall sell to his/her employer put options on the shares of the company at a strike 80% below the year-end stock price (the exact level could be determined by looking at how much bank stock prices fell in the recent financial crisis) and maturing in parts---beginning from the 6th year to the 15th year. The value of these options ought to be close to 10% (say) of the compensation i.e. US$ 50,000 in this case.
(Note: even if all such employees' compensation is corrected upwards by around 10% because of the options still the tail risk is borne by these employees!)
Furthermore, these employees (who write the options in favour of their employer) ought not be allowed to offset these positions with any systemically important institutions.
WHAT DO YOU THINK?
Posted by amgodbole at June 1, 2011 07:12 PM
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