Looking back five years to the subprime crisis, it is clear that one underlying cause was the conflict of interest caused by the way in which Wall Street structures compensation.
Traders - the agents of financial institutions - receive most of their compensation for taking risky positions. They are rewarded quickly via quarterly and annual bonuses, while those positions can potentially blow up years later. This structure creates an incentive for the agent to generate large volumes without caring about long-tail, long-term risks to the principal. Compensation structures haven't changed much, and the existing agent-principal conflicts will, sooner or later, cause yet another bubble.
Wall Street (and Dalal Street as well) lives with another conflict of interest due to "soft dollars". Brokerages offer "free" investment advice to clients and make it up in brokerage. The advice may, of course, be geared to generating trading volume, rather than generating higher returns.
Consulting major McKinsey had a two-decade internal argument about fee structures when it started servicing biotechnology and internet businesses. These clients preferred to pay in equity and some also negotiated for contingency fees and earn-outs. If McKinsey got them new business or saved expenses, it could keep a percentage of gains.
All these arrangements set up conflicts. The incentives to fatten fees may lead to advice that is not in the client's interest. Equity-based compensation is a minefield either way. If the company goes bust, the consultant gets zilch. If the equity rockets up, there are problems in the internal division of spoils. McKinsey set up a committee to value such unconventional structures. It decided that at least 50 per cent of fees had to be paid in normal ways to reduce, if not eliminate, such conflicts.
Agent-principal conflicts involving public servants are also at the heart of corrupt practices. The state has goals. If it structures compensation the wrong way, it creates the wrong incentives and the personal goals of its servants diverge from those of the state.
The state's compensation to bureaucrats and politicians has three components. It pays a salary, which isn't large. It also offers perks like housing, transport and various allowances. These have a value larger than the salary. But they are not easily monetised. The third component is power. Every public servant has some discretionary power. It is easy to monetise this and the monetary value is magnitudes more than salary and perks. This is where corruption starts.
Consider how much people are willing to spend to become members of Parliament (MPs) and match that against salaries and perks. An MP receives a tax-free salary and allowances of Rs 1.3 lakh a month, or Rs 78 lakh over a five-year term. If we assume the value of perks is about twice as much, we're talking roughly Rs 2.4 crore post-tax compensation over a full term.
The Election Commission has an official spending limit of Rs 2 crore per political party per constituency, including a candidate's personal expenditure limit of Rs 40 lakh. Estimates for actual spending per candidate per constituency range between Rs 5 crore and Rs 8 crore for every "serious" candidate. The difference between the election spend and what the MP receives in salary and perks is the lower limit of what the MP hopes to make by monetising the power component.
Similarly, rough estimates can be made about the monetisable value of an Indian Administrative Service, Indian Police Service, or Indian Revenue Service officer's power by offsetting the going dowry rates against the salary and perks, which the officer will receive over his career. The difference is the net present value of the projected future power component and it may run into crores.
The only way to reduce corruption is to reduce the power component, perhaps while hiking salary and perks. It is difficult to see this happening since the people who benefit from the current compensation structure are the ones who would have to opt to change it. This conflict of interest pretty much ensures that corruption is irreducible.
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
