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Morgan Stanley & AIG: Incentivizing Managers For The "Long Term" Sets Stage For Long Term Inefficiency

In an industry based on big deals which garner outsize fees and commissions, executive compensation is at the heart of the business. It's no surprise therefore that compensation-related dilemmas are lighting up like fireflies in the financial industry right now.

At the beginning of the year, firms witnessed an exodus of top bankers across the board, as high-level executives sought out opportunities in private firms where compensation plans are not restricted by today's endless list of government guidelines.

Now, in order to stem the hemorrhaging, Morgan Stanley is raising base-level salaries for its senior executives in order to compensate them for lost income due to shrinking bonuses. Under the new plans, managing directors will see their base salaries rise to up to 30% of their total compensation, from around 15% to 20% previously. That could mean that Morgan Stanley's top managing directors get $400,000 a year in base salary. The move is supposed to incentivize bankers for the "long term."

But here's the problem: while such salaries may generate some degree of long-term thinking, that's only among those who you don't want at the top of any institution for very long.

While the best of the bunch will still leave the bank for a private firm or a foreign bank where they can earn more money on a commission-based salary, those unable to generate big returns will be left occupying positions they would never have been in before.

In the end, that doesn't really help any of us sort out the mess that we're in. The whole reason Morgan Stanley survived the credit fracas intact is precisely because of the mishmash of fee and commission based businesses which fall under the bank's umbrella. While the new compensation plans are great for those in fee-based businesses, they're lousy for anyone running performance divisions such as sales and trading.

As a result, more traders and salespeople at Morgan Stanley are merely incentivized to move on to private boutique firms or worse still, foreign banks. That trend will end up culminating in big banks such as Morgan Stanley increasingly resembling the slow, lumbering Tokyo-based megabanks of the 1990's.

That model is a disaster for any kind of long-term economic development. Consider how uncompetitive Morgan Stanley now is vs. UBS, for example, which is free to set bonuses as it pleases this year.

I can't count the number of times that I've heard traders at Japanese banks only a few years into the job complaining that although they have long-term job security, they could earn much more at foreign rivals. As a result, banks such as Nomura and Mitsubishi UFJ, despite having big presences in key financial centers across the globe, end up achieving the exact opposite of what they intended, becoming career "stepping stones" for high performers.

There is a similar problem going on at AIG right now, too.

Lately, speculation is ensuing that AIG may be rejected by candidates unwilling to accept a pay cut to try to turn around the money-losing insurer.

"They're not going to be able to pay the next guy what he's worth, so that will limit the people they can get dramatically, I think you're looking at a retiree or a politician to step in there," Alan Johnson, managing director of executive compensation firm Johnson Associates told Bloomberg Friday. "It may cost the American people several billion dollars to save a few million dollars on salary."

And therein lies the crux of the problem with not compensating key people well enough to do crucial jobs. While it's politically palatable in the short term to limit executive pay, everyone ends up paying a far higher price in the long term as big institutions consistently underperform.

The drag on the economy created by that movement can be felt for years: just ask the Japanese.

Related Reading at BNET Finance:

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