Our Take: Limit Risk By Regulating Pay?

Corporate executives, Americans especially, are often chided for obsession with short-term profit. But short-term profit is the alpha and omega of how financiers get paid - from the chief executive to the lowliest trading assistant.

Now, some industry leaders are publicly acknowledging that banking's highly skewed compensation model may have helped cause the credit crunch by inducing participants to take excessive risks. More ominously, they're angling to do something about it. A high-powered group called the Institute for International Finance is drawing up an industry-wide compensation code. Along with other ideas for improving risk management, the IIF compensation plan will be sent along to global bank regulators, and could become part of a broad bank-reform agenda slated for discussion at a Group of Seven meeting next month.

The IIF is an umbrella group that combines bank leaders from the private sector, central bankers and regulators. Born in 1983 in the wake of Mexico's debt default, the institute is chaired by Josef Ackermann, the head of Deutsche Bank. The U.S. Fed was represented at the IIF meeting in Rio de Janeiro this week by Thomas Hoenig, president of the Federal Reserve Bank of Kansas City.

Straight For the Jugular

While details are vague at this stage, it's clear the pay plan's architects are going straight for the jugular: they're targeting bonus plans that handsomely reward bets that show early profits, with no possibility for clawback if the position or product blows up in a subsequent year. Banks' reliance on such "asymmetric" incentives "encourages employees to take excessive risks," declared Swiss central banker Philipp Hildebrand, as quoted in the Financial Times.

This is heady stuff. Until now, modifying Wall Street's bonus system is an idea I've seen touted mainly by populist politicians who wear their economic illiteracy as proudly as a campaign button, and by anonymous readers in comment threads on newspapers' Web sites. Now that it's being voiced by chief executives and central bankers, it's likely to gain a measure of credibility and respectability.

Whether such a change could work is anybody's guess. Even proponents like Ackermann admit that pay is an essential competitive tool for most banks, which makes reform difficult. Even if done in the name of better risk management, any tinkering with the "price" of the industry's central asset - its people - might heighten the risk of killing the goose that lays the golden eggs.

One-Sided Incentives

The Wall Street Journal's Heidi Moore aired further objections in a DealJournal post two days ago. Her points bear repeating - and in part, rebutting.

"Yes, the symbolic appeal of a Wall Street pay code is irresistible, but for all intents isn't there already one in place?" Moore asks. "Banks, for instance, do censure bankers and traders who don't make money, with a sliding scale that ranges from 'low bonus' to 'layoffs.'"

Well, no. If you've been paid $10 million for a series of deals that later go sour, getting a reduced bonus the next year or even getting laid off is hardly the kind of punishment that could persuade individual bankers or their bosses to consider longer-term risks when shaping deals. Similarly skewed incentives are at work when non-financial executives use aggressive (or even deceptive) accounting to inflate a company's reported profit. If they succeed in goosing the share price, they'll be greatly rewarded. Yet even after Sarbanes-Oxley, it is difficult for corporations to reclaim "performance" pay that a dismissed former executive might have stolen from shareholders by cooking the books.

Moore goes on to suggest that compensation guidelines might better suit European banks than American institutions. U.S. banks tend to be more generous at least at the chief executive level, she says, citing the relatively modest $4.9 million package of SocGen Chief Executive Daniel Bouton. (We think a more meaningful comparison would involve a larger institution with a bigger U.S. presence, such as UBS or Deutsche, and would focus on vice presidents to managing directors, rather than corporate officers.)

Finally, Moore sees no justification for regulating the pay of investment bankers, "who didn't spur the subprime disaster," alongside of traders, who presumably did. Not all bankers work in M&A, however. People who create and sell MBS, CDOs and other packaged bonds are bankers, too. And they were more mixed up in the sub-prime mess than any trader. Arguably, they bear even more blame than the retail bank staffers and mortgage brokers who originated sub-prime loans in the first place.