Reining in top banker pay does nothing to deter fraud down the ranks

All eyes have been on the world’s top bankers who took home as much as $21 million last year, but the stringent regulations on executive pay, performance and risk taking turn a blind eye on lower level bankers and traders who repeatedly get away with fraud.

The European Union is grappling with its plan to limit payouts to 100% of salary for employees earning a total of more than €500,000 ($662,850), and that could jump to 200% if shareholders allow it. That would do little or nothing to curb the risk-taking behavior of the likes of Fabulous Fab, the London Whale and the LIBOR conspiracy at Barclays.

“Senior executives will actively seek to revise the level and form of compensation for junior executives if they believe that that it is in the best interest of the institution,” says Brian Dunn, CEO of Aon Hewitt Performance, Rewards & Talent. “However, many of the proposed regulations will likely not be in the best interest of the institution and in this respect, unless they are required changes, institutions will most likely choose not to implement them.”

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Meantime, a proposal in the U.S. to bring back the repealed Depression-era Glass-Steagall Act could create a new breed of old-school trading houses that operate below the regulatory radar of a divided banking system and break down the barriers for would-be rogues. A new version of the law that was repealed in 1999 would separate commercial banking activities insured by the Federal Deposit Insurance Corp. from institutions that offer such services as investment banking, insurance, swaps dealing, hedge funds and private equity.

Before the financial crisis, the level of non-executive pay incentives was determined largely by the market demand for talent, and hiring typically is based on short-term results because it’s difficult to assess a prospective hire’s long-term performance. This invites non-executives to take on significant risks to shore up short-term performance and skip out before losses show up on the books.

In a new whitepaper draft, “Risky Business: Competition, Compensation, and Risk-Taking,” Cornell Law School Prof. Charles K. Whitehead argues that policymakers are wrong to presume that high-level bank executives will bring junior employees’ compensation into line once their own pay is regulated. Executive pay policies have done little to control how much mid-level and junior bankers and traders were paid, how they performed and what risks they incurred for banks leading up to the financial crisis, he says.

“The rewards are greater compensation from new or existing employers that compete for staff who performed well in the short-term,” says Whitehead. “Non-executive pay, therefore, is a function more of market demand—increasingly set by non-banks—than of what a bank’s executives believe to be optimal in influencing performance.”

Whitehead calls for new regulation to “address the tension between competition and compensation. Regulators should take account of the effect of competition on market-wide levels of pay, including by non-banks who compete for talent. The ability of non-executives to jump from a bank employer to another financial firm should also be limited.”

New regulation should also restrict an employer’s ability to offset losses that new employees incur based on compensation paid by a prior employer that is tied to long-term performance, says Whitehead.

Consider prime examples of traders who acted recklessly to make quick profits.

Fabrice Tourre was found guilty Aug. 1 on six counts of securities fraud, including one of “aiding and abetting” his former employer, Goldman Sachs. The former vice president misled investors about a complex security, called Abacus, which caused three financial firms to lose $1 billion. He said Goldman Sachs paid him a base salary of £ 480,000 pounds ($738,000) after he was put on leave following the filing of an SEC lawsuit in 2010.

Bruno Iksil, A.K.A. the "London Whale" at the center of the trading scandal that cost J.P. Morgan some $6.2 billion in 2012, will not be prosecuted by the Justice Department, The Wall Street Journal reported yesterday.  It’s unclear how much the top trader at the Chief Investment Office in London legally took home, but the debacle did have an upward effect: halving Jamie Dimon’s salary.

Competition drives the investment banking and trading worlds, and it’s easy to see how the pressure to preform can also lead to massive risk taking, especially among young and rising stars.

“We often think of competition as benefiting the marketplace,” Whitehead says. “It forces companies to keep prices low and quality high or, in the case of staffing, it helps in allocating the best employees to the most profitable firms. But competition can also have its costs.”

Whitehead calls for three major policy changes: regulators must compare how similar employees are paid by hedge funds, investment banks and others who compete with banks for talent; middle- and lower-tier employees must be restricted from switching jobs within the industry for a period of time; banks must be prohibited from compensating new hires for the portion a previous employer would have doled out for long-term performance.

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