Why curb pay? Try incentives instead

Why curb pay? Try incentives instead

Yours, assuming you are a banker, not theirs.

Our elected and appointed representatives appear to be capitalizing on public anger towards bankers and bailouts as an excuse for mission creep.

At a meeting earlier this month in London—a pre-summit summit, without the heads of state, to set the agenda for the summit—the G-20 finance ministers and central bank governors laid out a set of principles to prevent excessive short-term risk-taking and mitigate system risk.

In addition to the imposition of higher capital requirements and stronger prudential oversight, the officials want to introduce global standards on pay structure to better align compensation with performance and ensure financial stability.

Is there a connection? Or are governments using this as an opportunity to apply the Emanuel Doctrine, enunciated by White House chief of staff Rahm Emanuel?: Never let a serious crisis to go to waste. It’s an opportunity to do things you couldn’t do before.

There is something unseemly about government setting private sector pay. The fact that French President Nicolas Sarkozy and German Chancellor Angela Merkel are behind the initiative suggests an ulterior motive.

On the same page: (from left) US treasury secretary Timothy Geithner, UK chancellor of the exchequer Alistair Darling and France’s finance minister Christine Lagarde at the G-20 finance ministers and central bank governors’ meet in London on 5 September. Chris Ratcliffe / Bloomberg

There are two related strands underlying the drive to realign (read: harmonize and reduce) banker pay, according to Philip Whyte, senior research fellow at the Centre for European Reform, a London think tank. The first is the belief that financial sector pay is too high. The second is that the compensation structure contributed to the crisis, with incentives encouraging excessive risk-taking in pursuit of short-term profits.

My guess is most people think multimillion-dollar pay packages in the financial sector are outrageous, especially relative to recent performance. I’d also guess that most Americans, aspiring to wealth themselves, don’t want bureaucrats involved.

It’s one thing when the government is a stakeholder in a company, as it is with Citigroup Inc., Bank of America Corp. and American International Group Inc. We, the taxpayers, are involuntary owners of these companies and have no interest in rewarding failure.

It’s quite another when government has no ownership stake, where compensation is a matter for shareholders and boards of directors.

This level of government involvement may be business as usual for the European Union. In the US, where the Federal Reserve is cooking up a plan of its own to insert regulators into the compensation process, it reads like fake news from the Daily Show.

The good news is, the Obama administration isn’t wild about setting individual compensation. The bad news is, UK Prime Minister Gordon Brown is. He wants to set bonuses and sanction banks that don’t comply.

Can a one-world pay scale be far behind? That way, no financial institution would be tempted to depart the homogeneous European Union for what used to be the more capitalist-friendly, entrepreneur-oriented climes of the US and UK.

The French believe the financial crisis has discredited New York and London, Whyte says. At the same time, they see it as an opportunity for Paris to assert itself as a financial centre.

In other words, we don’t like your system, but we’re happy to pick up any crumbs.

Once global governments start setting pay scales and penalizing banks for non-adherence, it’s only a matter of time before they dictate what type of loans financial institutions should make to what classes of individuals.

Wait. They did that already. One of the key drivers of the housing boom-bust that triggered the financial meltdown—at least in the US—was government-directed lending for housing.

Homeownership-for-all became a national policy goal in the 1990s during the Clinton administration. (Laws to encourage homeownership in low-income neighbourhoods date back to 1977.) Lending standards went down, homeownership rates went up, peaking at 69.2% in 2004. Many buyers turned out to be owners in name only, with mortgages they couldn’t afford to begin with soon exceeding the value of their house.

The Europeans are correct when they point to misplaced incentives as a cause of the crisis. Mortgage lenders had no incentive to perform due diligence on loans, which flew out the door as quickly as they could be processed. Securitizers weren’t motivated to parse pools of mortgages as long as rating companies slapped a AAA rating on it. And so on down the line.

OK, bankers screwed up. What should we do about it?

The answer isn’t putting government bureaucrats on the compensation committee.

Public companies should pay bonuses out of pre-tax profits, says Michael Aronstein, president of Marketfield Capital in New York.

Another option is to replicate the type of liability that existed with private partnerships, he says.

The firm loses money, the officers, directors and top earners lose money.

If history is any guide, regulation—or, in this case, regulators—will prove to be unworthy of the competition. Bankers will find a way to evade the rules and exploit the loopholes to their own advantage.

It seems like a lot of wasted energy when, with proper incentives, these clever rascals would put their considerable talents to better use: working on behalf of shareholders. bloomberg

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