by Jennifer Carpenter, Thomas Cooley and Ingo Walter
Now that the Financial Reform and Consumer Protection Act of 2010 has been passed by both houses of Congress, one of the key aspects that bear watching will be its impact on compensation of senior management and highly compensated risk-taking employees - who generally take home around half of financial firms' earnings from wholesale banking activities.
Almost every investigation of the financial crisis has provoked a fresh round of public and political outrage as more details about compensation levels and practices at financial institutions have come to light. The increase in executive pay relative to median pay throughout corporate America has been a focal point of media and investor attention for some time, but compensation policy in the financial industry is among the most extreme. Regulators and politicians have been quick to count compensation in the financial sector as a major cause of the crisis, and many have advocated punitive taxation and direct regulation including caps on cash bonuses and floors on the proportion of share-based pay.
Our view is that compensation policy in the financial industry was not, by itself, a real cause of the crisis. Although astronomical levels of pay may offend most people's sense of fairness -- and wealth-redistribution as opposed to wealth-creation -- they are not in themselves destabilizing. What matters for financial stability is not the level of compensation, but rather the risk incentives it creates. Compensation structures during the period leading up to the crisis undoubtedly did create incentives to take risks that were excessive from society's viewpoint. But the source of this problem is that incentives for taking excessive risk are built directly into bank equity itself and consequently are a key responsibility of the board.
It's long been recognized recognized that holders of highly-levered equity, protected by deposit insurance or too-big-to-fail guarantees, have incentive to maximize the value of that equity at taxpayer expense by taking big bets. Capital requirements and restrictions on banking activity were supposed to address this conflict of interest between financial firm shareholders and taxpayers. But deregulation of banks and innovation in financial products either explicitly or effectively loosened these constraints. In retrospect, it seems clear that shareholders, and their boards, condoned and even encouraged many of the risky activities for which high-profile managers and traders have been blamed, such as accumulating large inventories of dodgy but profitable assets.
Some compensation practices, such as paying bonuses based on "fake alpha" (excess returns determining current bonuses that later turn out to be illusory), induced systemic risk at the expense of both shareholders and taxpayers. However, shareholders of the major financial firms evidently were largely supportive of compensation policy. Indeed, in the face of supervision that might have strengthened their hand at the bargaining table with highly compensated employees and managers, boards of bailed-out financial firms scrambled to pay back government loans primarily to regain freedom to grant the signing bonuses and pay guarantees they felt were necessary to attract and retain the talent they felt added value.
While we are in favor of compensation reforms in the financial sector, we argue that the solution is not direct pay regulation, involving hundreds of thousands of contracts between firms and highly compensated staff with heterogeneous preferences and skills, but rather a rewriting of the basic contract between taxpayers and the financial firms themselves. With new regulatory initiatives that place restrictions on lines of business that are protected by federal guarantees, correct pricing of deposit insurance, taxation of systemic risk, higher capital requirements, and other measures discussed in this book, much of the compensation problem is likely to resolve itself. If the incentives facing shareholders at financial firms can be better aligned with those of taxpayers, for example, through correct pricing of guarantees and taxation of systemic risk, then it remains only to strengthen shareholder rights as much as possible and leave shareholders representatives on boards to provide managers with the right incentives.
For this reason, we favor many of the G-20 and US legislative provisions for executive compensation. These strengthen shareholder rights by mandating nonbinding shareholder votes on executive pay and better disclosure of compensation policy and the permissibility of managerial hedging, yet do not tie boards' hands with more rigid regulation of compensation structure. We also strongly support the Federal Reserve's plans for regular review of compensation in the financial sector, and hope that it will generate a large database on compensation in the financial industry that will spur compensation reform in the future.
With sufficient alignment of taxpayer and shareholder interests, and sufficient strengthening of shareholder rights, we expect to see compensation reform emerge largely on its own. What might elements of sensible compensation policy at financial firms include?
• Stock-based or other performance-based pay, without predetermined minimums, to create an incentive to add value through efficiency and innovation;
• Ex-ante risk adjustment of performance measures, to discourage the pursuit of illusory "fake alpha" profit;
• Deferred cash compensation, or "inside debt," to give managers an interest in the long-term solvency of the firm;
• Claw-backs, or "maluses" to give managers a tangible personal interest in controlling downside risk;
• Guaranteed cash compensation (the G-20 recommendations notwithstanding) to attract and retain talented personnel and compensate them for the risks they may personally be forced to bear.
Note that our list does not preemptively include caps on cash compensation or floors on the proportion of stock-based compensation. More stock-based compensation might only aggravate the perverse incentives problem if taxpayer/shareholder conflicts persist. Capping pay also seems heavy-handed. For example, financial firms may need to raise cash compensation to managers in return for forcing them bear more downside risk in stock-based compensation and lock-ups. And we have noted that average pay levels at these institutions could very well decline on their own if the Volcker Rules and other restrictions on banking activity ultimately mean these firms find less use for high-priced talent, and the affected employees depart for better opportunities elsewhere.
Is endogenous compensation reform too much to hope for? Perhaps. But fixing the obvious conflicts between shareholders and taxpayers, strengthening shareholder power, and then giving market discipline a chance seems like the best place to start.