Our Take: Repairing the Pay Model

The current groundswell against Wall Street bonuses, while deeply flawed, is not entirely misplaced. Ongoing efforts by insiders acting in a spirit of analysis rather than blind anger, might well catalyze constructive change.

In two recent widely read commentaries, I exposed the overheated emotions and disregard for facts that undergird demands to stop banks - at least those receiving capital injections from the U.S. Treasury - from making any year-end bonus payouts for 2008.

That's not to say that Wall Street's compensation model can or should emerge intact from this crisis. Abruptly and indiscriminately docking pay for the broad mass of 850,000 U.S. securities and asset management workers would be both self-defeating and unjust. However, industry leaders would be wise to craft compensation reforms aimed at bringing risk and reward into better balance for 2009 and beyond. Indeed, boards of directors are starting to question basic compensation models, says Alan Johnson, a consultant who designs pay plans for large financial institutions.

Such reforms should aim not to appease the blood-lust of voters eager to punish anyone in sight for the present mess, but to dampen the perverse incentives that enabled this meltdown and will enable another one someday if left unchecked.

The trick is to do so without killing financial innovation - a goose whose golden eggs fed decades of global growth and prosperity. Is the goal achievable? I don't know, and I doubt anyone does.

'Best Practices' Aim to Tie Pay to Risk - Not Just Profit

The outlines of change were aired by a number of global bank executives and regulators as far back as last March - both in individual pronouncements and under the aegis of bodies such as the Institute For International Finance (IIF) and the Financial Stability Forum. Similar ideas had been sifted and weighed in professional, academic and policy journals long before then.

An IIF "Best Practices" report published in July linked the financial turmoil to "excessive risk-taking resulting in part from incentive compensation tied to revenue or short-term profitability." Bonuses sometimes were awarded "without sufficient regard for the risk and revenue profiles of products that often span several years," the report said. It recommended steps like:

- Basing bonuses not on a trader's raw profit, but on profit adjusted for risk and capital costs,

- Paying the lion's share of bonuses in the form of "deferred or equity-related components,"

- Timing payouts to correspond with the period in which a firm's capital is at risk, and

- Making incentives for risk-takers as comparable as possible across different business groups within a firm.

In short: Placing the world's financial system on a more stable long-term footing requires overhauling "heads I win, tails you lose" pay plans that let bankers take home millions for creating products or positions that show early profits, with no possibility for clawback if the position blows up in a subsequent year.

What About This Year's Bonus?

Short-term changes are in the cards too. Executive compensation for 2008 will inevitably be restrained both by the market meltdown and intense scrutiny from policy makers and the public following the taxpayer-funded rescue program. Johnson predicts that payouts for "proxy executives" (whose compensation is reported in corporate proxy statements) in firms receiving government aid will shrink far more than any other category of bank employees.

On Wednesday, the four major U.S. banking regulatory bodies issued a rare joint statement that included an order for banks to "regularly review their management compensation policies to ensure they are consistent with the longer-run objectives of the organization and sound lending and risk management practices." The statement also warned against paying shareholder dividends that could weaken an institution's financial health or its ability to lend.

Moves to shame bank CEOs and other senior executives out of accepting any bonuses for 2008 make much more sense than the parallel effort to withhold bonuses from the entire finance-sector workforce. For one thing, despite all the laws on corporate governance enacted over the years, most compensation commmittees are still in the CEO's pocket. So the public is right to believe that top executives "pay themselves." That may be the only sound-bite in the whole compensation debate that isn't just an urban legend.

But don't expect the top dog's loss to be your gain. In any institution, pressure on executive compensation has a trickle-down effect on employee pay. All else equal, the deeper a firm slashes incumbent executives' payouts, the harder its management is likely to clamp down on compensation for the rank and file.