Create An Ethical Culture and Reasonable Compensation Rules Will Follow

Bankers by now are pretty much resigned to suffering the punitive consequences of the great meltdown. Capital, liquidity and leverage requirements will tighten, some trading activities will be constrained, and prudential supervision will ratchet up. But for some executives, the postcrisis scrutiny of — and potential restrictions on — how they are compensated still stings.

While they may be ready to accept and comply with, for example, the U.S. Dodd-Frank Act’s shareholder “say on pay” provisions, and with even further-reaching U.K. and European rules and guidelines that are to take effect soon, high-ranking financial industry executives bristle at government intervention in an aspect of their jobs that they have always regarded as a free-market prerogative.

The distortions and excesses of the recent bubble are undeniable. “Conflicts of interest and the way CEOs are compensated are at the heart of this financial catastrophe that has wiped out trillions of dollars in assets and millions of jobs,” Hershey Friedman, professor of business and marketing at Brooklyn College, and Linda Friedman, professor of statistics and computer information systems at the Graduate Center of the City University of New York, wrote in the summer 2010 issue of the Capco Institute’s Journal of Financial Transformation. The prevailing ethic was “as long as there was money to be made, virtually no one said anything” about downside risks in the housing market, the collapse of which reverberated disastrously around the world.

John Taft, CEO of Royal Bank of Canada’s U.S. wealth management business and chairman of the Securities Industry and Financial Markets Association, concedes as much: “I think most people would acknowledge that poorly designed compensation was a contributor to the excesses that got us into trouble.” At Sifma’s annual meeting in November, U.S. Securities and Exchange Commission chairman Mary Schapiro said, “Compensation based on short-term numbers has to change.”

But what is the appropriate and effective policy response to inappropriately outsize pay? Will the Dodd-Frank-mandated disclosure of the relationship between total CEO compensation and the median of all company employees, or the U.K. tax on bank bonuses, abolish bad behavior and better align the incentives of executives with the interests of their marketplaces and shareholders?

Such measures bring no guarantees, because there is no defined connection between the sanction and the desired outcome. Short of direct governmental control over wages — a nonstarter virtually the world over — compensation is an elusive target. It is tied to, among other tangible and intangible factors, politics and behavior, which are hard-to-regulate aspects of human nature.

“At some point, you have to fall back on the character of the people involved in running financial institutions and the culture of those organizations,” says Taft. “You have to rely on them not to reward behavior that is excessively risky. That is not to say that compensation can’t be better designed.”

The professors Friedman asserted in their study that “the global financial crisis would not have occurred if executives were truly ethical.” If compensation is not easy to legislate, then ethics is surely impossible.

There are indications, too, that policymakers missed some key subtleties. René Stulz, who holds the Everett D. Reese Chair of Banking and Monetary Economics at Ohio State University, and Rüdiger Fahlenbrach, Swiss Finance Institute assistant professor at École Polytechnique Fédérale de Lausanne, published a paper in July 2009 exploring the “poor-incentives explanation of the crisis.” They “uncovered no evidence supportive of the view that better alignment of incentives between CEOs and shareholders would have led to better bank performance.” John Core and Wayne Guay, accounting professors at the Wharton School of the University of Pennsylvania and avowed skeptics of proposed compensation regulations’ ability to achieve their objectives, wrote in January 2010 that “current regulations are based on arguments that U.S. CEO pay is too high and performance incentives too low” — assertions that “do not appear well-supported by evidence.”

University of Minnesota Law School professor Richard Painter is no less convinced that a lopsided incentive system is implicated in poor management quality and decisions, but he favors a behavior-based corrective. Collaborating in research with law school colleague Claire Hill, Painter proposes making highly paid employees personally liable in cases of insolvency and deferring pay in the form of assessable stock that would be exposed to company failures.

“I would just federally require it,” says Painter. Short of that, clients or corporate governance advocates could push for it. Either way, this well-aimed idea has an elegance that reflexive regulatory reactions have lacked. • •

Jeffrey Kutler is editor-in-chief of Risk Professional magazine, published by the Global Association of Risk Professionals.