[corp-focus] Getting Wall Street Pay Reform Right

[robert weissman]

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Getting Wall Street Pay Reform Right
By Robert Weissman
September 25, 2008

There's mounting talk on Capitol Hill that a Wall Street bailout will 
include some limits on executive compensation, as well as contradictory 
reports about whether a deal on controlling executive pay has already 
been reached.

Four days ago, such a move seemed very unlikely. But the pushback from 
Congress -- from both Democrats and Republicans -- has been surprisingly 
robust, thanks in considerable part to a surge of outrage from the public.

Will restrictions on CEO pay just be a symbolic retribution, as some 
have charged?

The answer is, it depends.

Meaningful limits not just on CEO pay, but also on the Wall Street bonus 
culture, could significantly affect the way the financial sector does 
business. Some CEO pay proposals, by contrast, would extract a pound of 
flesh from some executives but have little impact on incentive structures.

There are at least five reasons why it is important to address executive 
compensation as part of the bailout legislation.

First, there should be some penalty for executives who led their 
companies -- and the global financial system -- to the brink of ruin. 
You shouldn't be rewarded for failure. And while reducing pay packages 
to seven digits may feel really nasty given Wall Street's culture of 
preposterous excess, in the real world, a couple million bucks is still 
a lot of money to make in a year.

Second, if the public is going to subsidize Wall Street to the tune of 
hundreds of billions of dollars, the point is to keep the financial 
system going -- not to keep Wall Street going the way it was. Funneling 
public funds for exorbitant executive compensation would be a criminal 
appropriation of public funds.

Third, the Wall Street salary structure has helped set the standard for 
CEO pay across the economy, and helped establish a culture where 
executives consider outlandish pay packages the norm. This culture, in 
turn, has contributed to staggering wealth and income inequality, at 
great cost to the nation. We need, it might be said, an end to the 
culture of hyper-wealth.

Fourth, as Dean Baker of the Center for Economic and Policy Research 
says, the bailout package must be, to some extent, "punitive." If the 
financial firms and their executives do not have to give something up 
for the bailout, then there's no disincentive to engage in unreasonably 
risky behavior in the future. This is what is meant by "moral hazard."

If Wall Street says the financial system is on the brink of collapse, 
and the government must step in with what may be the biggest taxpayer 
bailout in history, says Baker, then Wall Street leaders have to show 
they mean it. If they are not willing to cut their pay for a few years 
to a couple of million dollars an annum, how serious do they really 
think the problem is?

Finally, and most importantly, financial sector compensation systems 
need to be changed so they don't incentivize risky, short-term behavior.

There are two ways to think about how the financial sector let itself 
develop such a huge exposure to a transparently bubble housing market. 
One is that the financial wizards actually believed all the hype they 
were spreading. They believed new financial instruments eliminated risk, 
or spread it so effectively that downside risks were minimal; and they 
believed the idea that something had fundamentally changed in the 
housing market, and skyrocketing home prices would never return to earth.

Another way to think about it is: Wall Street players knew they were 
speculating in a bubble economy. But the riches to be made while the 
bubble was growing were extraordinary. No one could know for sure when 
the bubble would pop. And Wall Street bonuses are paid on a yearly 
basis. If your firm does well, and you did well for the firm, you get an 
extravagant bonus. This is not an extra few thousand dollars to buy 
fancy Christmas gifts. Wall Street bonuses can be 10 or 20 times base 
salary, and commonly represent as much as four fifths of employees' pay. 
In this context, it makes sense to take huge risks. The payoffs from 
benefiting from a bubble are dramatic, and there's no reward for staying 
out.

Both of these explanations may be true to some degree, but the 
compensation incentives explanation is almost certainly a significant 
part of the story.

Different ideas about how to limit executive pay would address the 
multiple rationales for compensation reforms to varying degrees.

A two-year cap on executive salaries would help achieve the first four 
objectives, but by itself wouldn't get to the crucial issue of incentives.

One idea in particular to be wary of is "say on pay" proposals, which 
would afford shareholders the right to a non-binding vote on CEO pay 
compensation packages. These proposals would go some way to address the 
disconnect between executive and shareholder interests, reducing the 
ability of top executives to rely on crony boards of directors and 
conflicted compensation consultants to implement outrageous pay 
packages. But while they might increase executive accountability to 
shareholders, they wouldn't direct executives away from market-driven 
short-term decision making. Shareholders tend to be forgiving of 
outlandish salaries so long as they are making money, too, and -- worse 
-- they actually tend to have more of a short-term mentality than the 
executives. So "say on pay" is not a good way to address the multiple 
executive compensation-related goals that should be met in the bailout 
legislation.

The ideal provisions on executive compensation would set tough limits on 
top pay, but would also insist on long-term changes in the bonus culture 
for executives and traders. Not only should bonuses be more modest, they 
should be linked to long-term, not year-long, performance. That would 
completely change the incentive to knowingly participate in a financial 
bubble (or, more generously, take on excessive risk), because you would 
know that the eventual popping of the bubble would wipe out your bonus.

Four days ago, forcing Wall Street to change its incentive structure 
seemed pie in the sky. Today, thanks to the public uproar, it seems 
eminently achievable -- if Members of Congress seize the opportunity


Robert Weissman is editor of the Washington, D.C.-based Multinational 
Monitor, <http://www.multinationalmonitor.org> and director of Essential 
Action <http://www.essentialaction.org>.

(c) Robert Weissman

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