Centre for Economic Policy Research

5.8.2
The problem of compensation and incentives
Central to the decision of the degree of corporate separation is the problem of 
setting the incentives and compensation for managers. The pre-1933 experience
in the United States of universal banking shows, in extreme form, the dangers
when incentives are not adequately aligned for managers. The ability of officers
and directors to benefit from establishing their own partnerships that 
participated in syndicates with their insurance companies and securities affiliates
72 Conflicts of Interest in the Financial Services Industry

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created unusual opportunities for exploiting conflicts of interest. The partnerships
established by officers of Enron are the contemporary equivalents. The conflicts
are blatant as they provide compensation to officers that directly diminish the
revenues of their companies. These problems may be eliminated either by regula-
tion or ensuring that relationships are sufficiently transparent to the 
shareholders.
Within a bank, incentives also need to be properly aligned. If there is a 
booming stock market, with soaring revenues from IPOs, any misalignment of
compensation of executives within a firm may induce an exploitation of conflicts
of interest. As seen in Chapter 2, underwriters may pressure analysts and 
commercial bankers to assist them. How to design a management compensation
scheme that maximizes shareholder value is the central problem. While there is
no simple guidebook, the example of the National City Bank’s management fund
is an insightful approach. By pooling the revenues from commercial and 
investment banking and allotting them to the shareholders and managers in a
fixed ratio, managers were treated as large shareholders. There was no incentive
for them to favour one unit of the bank over the other unless it maximized 
shareholder wealth. 
One danger that arises from even the best-designed management compensa-
tion system is if the time horizon of managers differs from shareholders. Managers
might be willing to favour underwriting customers over depositors, brokerage
clients or insurance policy holders if the profits from underwriting are high in the
short-run and they have a short-run horizon. In this case, they will not be con-
cerned about the long-term reputational effects of this favouritism on commercial
banking, brokerage or insurance. Whether shareholders can effectively monitor
managers to ensure that their behaviour is aligned with maintaining the reputa-
tion and value of the firm depends on the bank’s transparency and disclosure.