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Executive pay is only part of the problem

Cutting compensation of corporate titans saved by the taxpayers is fine, but there are bigger problems on Wall Street.

October 24, 2009

The financial industry has bounced back so strongly from last year's credit crunch that many Wall Streeters are looking forward to the kind of six-figure bonuses they enjoyed at the height of the housing bubble. But Washington isn't ready yet to shrug off the deep recession. This week, the Treasury Department's "pay czar," who was appointed to oversee seven financial companies and automakers rescued by the Troubled Asset Relief Program, slashed the salaries of the highest-paid executives at those firms, and the Federal Reserve proposed to oversee the pay of any bank employee who could significantly increase the bank's risk.

We have no quarrel with the government cracking down on compensation at Citigroup, American International Group and other companies that were saved by the taxpayers. If the pain of lower bonuses motivates those enterprises to pay back the Treasury sooner, that would be a good thing for all concerned.

The Fed's move to regulate the rest of the banking industry, on the other hand, is a decidedly mixed blessing. Sensibly, the Fed has proposed to look more closely at the biggest institutions and to take a flexible approach instead of seeking to cap the size or dictate the composition of a banker's pay. Its involvement could help counteract the competitive pressures that make it hard for a bank to abandon generous but imprudent practices embraced by its rivals.

Yet the Fed's record in spotting dangerous trends isn't reassuring. And pay structures don't encourage excessive risk-taking nearly as much as the incentives in tax and regulatory policies that encourage banks to borrow money instead of issuing stock and to bet on mortgage-backed securities instead of individual mortgages.

The most damaging factor may be the implicit guarantee the Bush and Obama administrations gave to companies that became deeply intertwined with other big financial firms. The protection for "too big to fail" companies undermined the natural incentive Wall Street firms had to manage risk. With no such backstop, companies would make their pay packages more sensitive to results over the long term, including provisions to reclaim bonuses if deals go bad over time. In fact, some firms are doing this already.

Rather than focusing on the king's ransom some bankers receive, Washington should look at the bigger problems in the financial industry. The Obama administration has offered a good starting point with its proposal for protecting against systemic threats, which would help reduce the risk of taxpayers having to bail out big Wall Street bankers again. Another important step is to make it easier for banks, shareholders and regulators to gauge the risk posed by credit derivatives and other complex financial instruments; the House Financial Services Committee just approved a bill (HR 3795) whose goal is to do just that. Finally, publicly held companies should let shareholders advise them before approving pay packages and let them vote directly on board members -- a move that could make the directors in charge of compensation think twice before offering executives salaries that aren't aligned with the company's performance.

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