Compensation Reform Now to End the Insanity

Written by Jim McGrath Monday, 03 August 2009 21:04

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BANKING REFORM NOW, END PERVERSE

BONUSES FOR THE BIG BOY NETWORK

What we need is a return to sensible banking and finance. The financial system can and must downsize by ending its practices of overleveraging, of growing "too big to fail" and of pursuing great risk for high fees at the cost of sound investment, and worst of all, bonuses and increasing salaries for those who created this crisis in the first place. All these practices, developed in the recent past, must be abandoned.  Back when banking was sensible, the reward for running your company into the ground by risky, fraudulent or overleveraged investments was job loss, but is now  millions in bonuses and raises -- the same perverse mindset that got us into this crisis by encouraging excessive risk taking without any threat of loss.

Now government guarantees against their losses mean more of the same, continuing a vicious cycle that has already begun to ruin the financial system.

On the contrary, the American people thought this would end, and certainly did not suspect that these perverse incentives would continue after government bail-outs.   They have essentially used taxpayer money to continue their existence as a grave, huge sized threat to our system. Obama and company must find a way to make them fail safely, or break them up so they are no longer too big to fail. We have anti-trust laws for this very purpose.  

It's time the politicians acted and return the bankers to good sense, whether they like it or not.  One New York Times good editorial accurately observes that we must fast-track reform that will work: tying compensation to performance and longterm investment success, and incentives to limit their size and excessive risk taking, at: http://www.nytimes.com/2009/07/27/opinion/27mon1.html

July 27, 2009  Editorial

Of Banks and Bonuses

Earlier this month, when Goldman Sachs reported record quarterly profits - and prepared to pay juicy bonuses - it was widely, and correctly, noted that the firm was leading the way back to a future in which outsized pay for short-term gains could once again foster excessive risk taking.

Sure enough, last week, Morgan Stanley explained its quarterly loss by saying that some of its traders were still "gun shy" after last year's near-death experience in the financial markets, but that the firm now planned to increase its risk taking. To try to stay competitive with Goldman and other banks, Morgan Stanley has also allocated a big chunk of its net revenue for compensation.

This from a couple of firms that 1) probably wouldn't even be around today were it not for ongoing government rescues of the financial system and 2) by dint of being too big to fail, now enjoy an implicit guarantee of future bailouts if their bets go wrong. The financial system may be stabilizing for now, but the danger to taxpayers if markets were to buckle again is at least as great as ever.

Financial regulatory reform is supposed to control that danger. For example, both the Obama administration's proposal and ideas from Congressional committees sensibly call for banks to hold more capital with which to absorb losses. A wise variation on that basic notion is that the bigger the bank, the higher the capital requirement should be. Insurance premiums paid to the government could also increase along with a bank's size. Such provisions would create incentives for banks to limit their size and in so doing, reduce the risk they pose to the system.

The problem is that the bonus-driven risk culture is reasserting itself now, while comprehensive reform will probably take until next year, if it occurs at all. A solution is for Congress to handle bankers' compensation as a stand-alone issue, as the House Financial Services Committee has said it is ready to do. There is no question about the need to end the perverse incentives that helped to set off the financial crisis. There is ample, and justified, anger among Americans about outsized pay - often to the very same bankers who profited from the bubble - to warrant fast-tracking the issue.

Among the needed pay reforms are rules to tie executive payouts to long-term results, like prohibitions against cashing out equity-based compensation until many years after options or shares have vested. Bonuses need to be delayed to ensure that the profits on which they are based do not prove transitory. An insightful reform recommended by Lucian Bebchuk, a Harvard Law professor and director of the law school's Program on Corporate Governance, would require that executive compensation be tied not only to the company's stock performance, but also to the long-term value of the firm's other securities, like bonds. That would encourage executives to be more conservative about using borrowed money to juice returns to capital, because it would expose them to the losses that leverage can exert on all the firm's investors.

Reforming the way bankers and traders are paid needs to be part of a newly regulated financial system. But it needn't and shouldn't wait for comprehensive reform to see the light of day.