What 1930s incentives schemes can teach us about bankers

Following the restructuring of General Motors (GM) in the mid-1920s an innovative incentive scheme was planned to align the interests of GM’s new management with those of the company’s stockholders. First  of all, the incentive scheme involved the purchase of GM stock at market value – that is, without discount – by the group’s Executives, via the General Motors Management Corporation (GMMC).

The shares were purchased largely on credit with $5,000,000 in cash and $50,000,000 in 6 percent notes. The payments for these notes were six annual amortized payments of $7,000,000 followed by a bullet payment on the principal of $8,000,000, payable in 1937.  

GM’s scheme differs in large part from modern incentive schemes because the scheme involves the purchase of shares by management rather than the awarding of stock options. The long term structure of this incentive scheme is in marked contrast to modern schemes where the vesting periods of stock options are relatively short.

The short termism options incentivise can have deleterious effects on firm performance, even as it boosts short term share performance.  

  1. Options can provide incentives to engage in excessive risk taking in an effort to increase share price, as if the share price does not move above the excise price then no gain is realised.
  2. Likewise, once it seems clear a stock will not gain in value the incentive to engage in effective management will be lessened.

As the GM scheme involved the ownership of GM stock the incentive to work to improve the company’s performance remained even if the share price decreased, as mangers were keen to avoid a loss as much as realise a gain. Managers shared both upside and downside risk.

Another difference between GM’s 1930s and modern schemes is that shareholders exercised much more power of the executives involved in the scheme than they do today.

For example, in the early years of the bonus scheme, GM’s shares were suffering from the deleterious effects of the Great Depression. This meant that the GMMC suffered as it shared the downside risk of a poor company performance.

No forgiveness was permitted until significant improvement in the stock’s performance, which finally appeared in 1934 when the company agreed a small forgiveness to take place. By 1937 shares had reached new heights of $65 and for each $1,000 dollars invested in 1930 was $12,595 during the Great Depression. The incentive scheme worked, GM’s shareholders custoemrs and managers were all rewarded handsomely.

In contrast, in early 2010 when the employees of Britain’s financial sector were threatened with a reduction in their bonus due to a one off tax, the bonus pool increased to offset these effects (The Guardian 2010).

This implies the incidence of the tax was on shareholders not bankers. Although the exogenous variable is difference – a tax not a depression – it illustrates modern incentive schemes can fail to aligns the incentives of owners and managers.

However, it is unlikely that schemes similar to GM’s will be introduced on a large scale today. GM’s scheme only became possible in the 1930s due to the reduction in labour turnover of the 1920s, before which such long term incentives would have made little sense. Workers in the modern financial sector where incentive schemes are conspicuous is characterised by a high staff turnover and long term incentive schemes may therefore not be attractive enough to attract willing participants.

The powever which bankers can excercise over the people who employ them is such that it may be impossible to productively align incentives between those that own and those that work at the banks. That is bad for banks, and it is bad for society at large.
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Holden (2005), “The Original Management Incentive Schemes,” Journal of Economic Perspectives, 19(4), 135-144.

The Guardian (2010) “Tax yield from bankers’ bonuses will top £2bn” by Nick Mathiason 28 February 2010 http://www.guardian.co.uk/business/2010/feb/28/bonus-tax-receipts-exceed-estimate [last accessed 12/01/11]

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