Our Take: Compensation Reform Returns

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When Wall Street compensation roared into the policy spotlight at the turn of the year, the debate resembled a bubbling cauldron about to spill over. Although the temperature is a great deal lower today, the compensation pot continues to simmer as new ingredients get thrown in.

The traditional emphasis on variable pay via the year-end bonus is likely to survive. The bonus system might even regain some lost ground, now that the mass hysteria that prevailed some months ago has subsided. But tomorrow's pay packages might contain more bonus deferrals, longer lookback periods and greater possibilities for clawback.

The Wall Street Journal reported Wednesday the Obama administration is beginning to weigh policies for long-term reform of bankers' compensation. The administration's effort is said to center around broad policy goals - not specific pay caps like the laws and regulations enacted in late 2008 and early 2009 for executives at institutions that took taxpayer aid. The emerging policies also are meant to cover a wide range of institutions, rather than only bailout recipients.

Don't Mistake Rhetoric For Substance

Any reforms should aim to discourage hidden buildups of risk by better aligning pay with trading results over periods longer than the 12-month lookback that's dominant today. Officials are examining various tools - supervision by the Fed and/or the SEC, "moral suasion," and of course, legislation - that could be used to implement any new policies that emerge. The WSJ gives no indication when reforms might be announced, beyond saying they would likely come as part of a broader financial-markets re-regulation program the Treasury Department is spearheading.

In analyzing any policy proposal, it's vital to distinguish between concrete program details and the rhetoric used to sell them to the masses. When the administration eventually rolls out its compensation plan, the president and his aides probably will lay on the populist imagery. But don't confuse the approaching, thoughtful phase of compensation reform with the punitive Robin Hood-style restrictions that dominated the public agenda last autumn (immediately after Lehman Brothers blew up and several other major institutions had to be bailed out) and again in March (when a few scandal-hungry editors and politicians repackaged a year-old, widely known AIG bonus "story" as though it were a new and shocking revelation).

A carefully crafted compensation reform program could remove most of the perverse incentives that enabled the current meltdown and would enable another one someday if left unchecked. That's why, at the same time I condemned various moves by politicians to exploit the electorate's ignorance and envy of bankers, I identified and endorsed other reform efforts that were structured to generate not heat, but light.

Global Best Practices

The Institute of International Finance, an umbrella group comprising global bank executives, central bankers and regulators, has been prominent in those efforts. As far back as February 2008 - before Bear Stearns was rescued - the Washington-based IIF was drawing up a "best practices" code designed to remove incentives for traders to take excessively risky bets that could destabilize their institutions and contribute to systemic risk.

Two IIF recommendations are: "Payout of compensation incentives should be based on risk-adjusted and cost of capital-adjusted profit and phased, where possible, to coincide with the risk time horizon of such profit."

And: "Severance pay should take into account realized performance for shareholders over time."

This March 30, the institute said most of its 380 member firms are moving "on an urgent basis" to implement seven compensation principles set forth in a July 2008 "market best practices" report. A survey for IIF by consulting firm Oliver Wyman found a number of firms have already developed "systematic approaches towards reflecting risk in performance measurement, handling deferred compensation mechanisms and establishing sound governance standards for the overall compensation process." Although the survey report mentions no names, that passage probably refers to new bonus rules unveiled late in 2008 by UBS, Morgan Stanley and Credit Suisse, among others.

How do the compensation policies the Obama administration is cooking up compare with the IIF advice? It's too soon to tell. But after reviewing the IIF reports on this subject, I hope the administration and Congress will proceed down the same path. If they opt instead to reinvent the wheel, they just might end up reinventing the flat tire.

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