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Executive Compensation: Why the Fed Should Steer Clear of Banker Pay

Pity the poor bankers. Not only are they Michael Moore's latest target and fodder for late-night talk show hosts, but now the Federal Reserve is proposing to oversee the details of their multimillion-dollar paychecks. This is a separate effort from the proposals by Kenneth Feinberg, compensation consultant to the Obama administration, to change the pay practices for top executives at companies the government has bailed out like AIG, Bank of America, Citigroup, and GM.

Feinberg’s proposals to shift a portion of executive salaries into stock options that would not vest for several years are interesting because they hint at how the administration is thinking about the issue, but they are far less sweeping than what the Fed is planning to do. For the first time, the Fed could reject pay policies it deems too risky, misguided or short-term-oriented. Regulators would have the right to scrutinize, and change, the fine print in the contracts of even mid-level traders and executives. Such judgment calls had previously been considered the exclusive province of management and boards. The proposals are, by any measure, an extraordinary expansion of the Fed's prerogatives.

Perhaps aware that their popularity ranks somewhere between Kim Jong Il and Jon Gosselin, the bankers are not squawking too much, at least not in public. Scott Talbott, the senior vice president of government affairs at the Financial Service Roundtable, a trade group representing top financial companies, is broadly supportive of what the Fed is trying to do, or at least he’s not one to tilt at windmills. “Risk management is the right concept,” he says, “and we recognize we need to do better.”

What the industry really didn’t want, he adds, was a hard limit on compensation, and the Fed isn’t going there. Besides, Talbott says, the banks are already doing, in one way or another, many of the things the Fed is talking about. What he didn’t say, of course, is that regulated financial institutions are so wedded to the Fed right now, in terms of bailouts and other kinds of government support and guarantees, that they are not eager to pick a public fight, particularly over an issue on which their credibility is so compromised.

So if the Fed is eager to do this, and the industry isn’t fighting it, what’s the problem? Well, not to rain on this parade of good feelings, but having the Fed oversee bankers’ pay won’t solve much. For proof, look to previous government efforts to curb executive pay, which are notable for only one thing: their failure.

If at First You Don’t Succeed ...

In the 1970s, the Nixon administration tried to limit salary increases to 4 percent in order to rein in inflation. In finance, however, what was meant to be a limit quickly became a minimum; salaries ballooned as soon as the controls ended. In the 1980s, Congress tried to restrict “golden parachutes” for departing senior executives; the result was that more people got them. In the 1990s, the government tried to limit executive pay by amending the tax code so that salaries above $1 million were no longer deductible to the employer. The inevitable result? Executives loaded up on pension goodies, deferred comp, and stock options, which ended up being far more lucrative — and distorted incentives much more — than mere cash.

Second, the Fed’s own record of risk management hardly recommends it to be judge and jury over others. Its policies of ultra-low interest rates, year after year, helped to inflate the housing bubble, after all. The Fed also allowed brokerages to increase leverage to unprecedented levels, a prime source of the recklessness that did so much to turn a downturn into a crisis. Bear in mind, too, that the mortgage-backed securities that injected so much poison into the system were not considered risky at the time. Most were AAA-rated; that is, they were seen as low risk, and many financial institutions cheerily leveraged up on that basis. So it is not obvious that having the Fed monitor the banks for “excessively risky” practices would actually result in a healthier risk profile.

Third, any action brings a reaction. If the Fed goes too far, expect an exodus out of the banks into the less-regulated parts of the financial industry, such as private equity and hedge funds. And a serious loss of talent in the banking industry is no recipe for stability or recovery.

Finally, even given the manifold mistakes the banks have made, it’s hard to believe that regulators, who are by design divorced from market signals, are in position to make better compensation decisions than managements. “It’s a bad idea,” says Charles Elson, head of the Weinberg Center for Corporate Governance at the University of Delaware. “The Fed does not have experience in setting pay. Government-imposed restrictions will only lead to brain drain or evasion.” Yes, says Elson, misguided compensation practices did encourage poor decision-making and unsustainable levels of leverage. But he believes the answer is in independent and accountable boards that know their companies and can make changes precisely, efficiently and in the interest of their shareholders.

And in fact, this is happening: Mugged by reality and nudged by their boards, many banks are casting a steely eye at the pay practices that helped send them off the cliff. Citigroup, Credit Suisse, and UBS are instituting “clawback” policies so that people who make decisions that go terribly wrong down the road have to give up some of the money they made off them. And Morgan Stanley and Bank of America are de-emphasizing bonuses and raising salaries.

What the Fed Should Do

A better approach for the Fed would be to set general principles to ensure that traders and other executives don’t get rich off making big mistakes, and let the companies themselves determine the specifics. Because if the overall building is sound, will anyone care that some of the architects are making a lot of money?

For example, there is a good case for increasing capital requirements. Yes, this would have the effect of reducing the amount of cash available to be turned into credit; but it would also mean that banks would have the reserves to cover their losses, instead of taxpayers doing the job for them. Leverage limits should be reduced. So should the use of special-purpose vehicles and other off-the-books assets, which are often designed to obscure rather than reveal the realities of the balance sheet, as Enron so eloquently demonstrated.

For commercial banks, “risk retention” rules bear looking into. One of the reasons mortgage-backed securities spread so far and wide is that they kept being re-packaged and re-sold. Bankers collected sweet fees for packaging them, but had little incentive to evaluate the quality of the loans. If banks had to keep a share of each loan, something on the order of 5 percent, they would cast a much hairier eyeball on borrowers’ ability to pay. Having skin in the game is a great form of risk management. Traders and brokers could still make fortunes; the point is that they wouldn’t make them on bets that they didn’t believe in enough to risk some of their own cash.

One more option is to require banks to put bonus money into escrow accounts that pay out over a period of years, rather than upfront. That way, if some bets go south, the bank keeps some of the cash. For banks that do not want to offend their traders this way, an alternative would be to require traders to bet some of their own cash; with their own money in play, they might be less likely to launch a Hail Mary transaction in which they are paid handsomely if it flies, and still paid if it bombs.

“If the Fed can bring everything together in one place with one set of [banking practice] standards, this could end up being a wise use of its power,” concludes Joe Sorrentino, managing director of Steven Hall & Partners, a New York-based executive compensation consulting firm. The fear, though, is that by getting involved in areas where it has no competence, the result will be bad policy. Indeed, some still argue that the Fed ought to just get out of the way. “We’re all for more intelligent compensation polices,” writes a former master of the universe, Henry Blodget (who, it should be noted, was banned from the securities industry for life by the SEC). “But these should come from Wall Street, not Washington.”

In the best of all possible worlds, maybe. But self-regulation is a tough sell right now. The public is genuinely angry as rich bank executives get richer while millions of others suffer a world of hurt (Ken Lewis’s good-bye present of $69 million from Bank of American, which received $25 billion in a taxpayer-funded bailout, will do nothing to assuage those hard feelings).

Wall Streeters can grumble that the banks are already doing a lot of what the Fed wants, and that jumping into pay decisions is more nanny-state interference from an administration that cannot resist the itch to micro-manage. They may even be right. But, as Sorrentino puts it, “They put themselves in this boat.” If the banks had been better at cleaning up their own messes, or better yet, not getting into them in the first place, the Fed would have stayed on the sidelines.

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