Both Senators Barack Obama and John McCain have criticized the seven- and eight-figure paychecks that Wall Street’s top brass collected in recent years while driving their companies — and the entire financial system — into the ground.
Both candidates have said the heads-we-win, tails-you-lose pay schemes that seem all too common in finance lie at the heart of the crisis that threatens the whole economy. Even some senior executives have told me that they agree.
Many people agree that the pay system is broken. It is clear that rewarding executives for delivering a few quarters of outsize profits or a share price that keeps rising (until it doesn’t) only encourages those executives to take risks. And managing risks hasn’t exactly been Wall Street’s forte lately.
The question is, how should pay be fixed? Now that American taxpayers are shareholders in the nation’s largest banks, a bevy of plans are making the rounds.
Some in Washington want to cap pay, period. Executives can make only so much and no more.
Others argue for “claw-backs.” That is, they want executives who got rich while their companies were reporting fat profits to be forced to give some of the money back. After all, much of the industry’s profits from the boom have been vaporized in the bust.
And still others have even come up with fancy formulas to rein in pay.
The issue has become such a nail-biter for big banks that some are even considering curbing pay voluntarily. Top executives hope such a move, coming in a year when pay is already plummeting, might quiet the complaints.
It won’t.
While various plans are being bandied about, one in particular deserves attention. It comes from Raghuram G. Rajan, a professor of finance at the Graduate School of Business at the University of Chicago and former chief economist at the International Monetary Fund.
Mr. Rajan is a longtime critic of executive pay on Wall Street. But he’s not a knee-jerk, all-big-bonuses-are-bad critic. Instead, he’s a pretty thoughtful, pay-for-performance capitalist who has been studying ways to create the right incentives for the system to work.
He has a multifaceted approach that would give banks a choice. Under the first option, the government would strictly regulate compensation formulas. Under the second, banks could pay their executives whatever they like — provided the banks set aside more capital. In other words, banks that cling to their free-wheeling ways would have to pay some sort of price.
For Mr. Rajan, this is an either-or proposition. If banks pursue current compensation policies — what might be described as the “no-responsibility” system, given the trouble we’re in — that’s fine.
But if that happens, “the government should levy more capital requirements against the bank,” he said. Requiring banks to have higher capital requirements would reduce the risk that executives will make stupid decisions that imperil the firm and, possibly, the nation’s financial health.
How much extra capital? That depends. If banks spread out executives’ pay over, say, four years, giving their executives an incentive to make smart decisions for the long haul, the banks would be allowed to set aside a bit less additional capital.
Ditto if they included claw-back provisions and required executives to reinvest a substantial portion of their income in their companies so they had some skin in the game.
“We need to make people a little more worried about the future,” Mr. Rajan said. The way things are now, executives are encouraged to take big risks because they get paid based on the immediate fees generated. They have little incentive to worry about what might happen to the balance sheet later.
Mr. Rajan said he was unimpressed by efforts to pay executives partially in stock. Owning shares in the entire company doesn’t tie bankers’ compensation directly to the decisions they make within their own units. “Stock compensation doesn’t do it because it’s too broad,” he said.
More important, Mr. Rajan wants executives to be paid over a four-year period, receiving a fourth of their bonus income every year. If they make a bad bet, they won’t get paid the remaining amount.
And Mr. Rajan thinks bonuses should be based strictly on what he calls “accounting performance,” rather than stock performance, which he says you can’t control. He also wants chief executive pay to be benchmarked against the performance of rival firms. If a firm’s earnings are worse than their rivals’, “why should they get a bonus?” he asked.
Despite all the criticism that hedge funds get for their compensation structures — they charge one fee up front, and take a big cut of any profits — Mr. Rajan likes part of the hedge-fund model: what is known as a “high water mark.”
When hedge fund managers lose their investors’ money, the managers don’t collect any of that fat incentive fee until they make back the loss. The same rule should be applied to bankers who destroy shareholder value.