Compensation issues take center stage in reform discussions

Compensation at financial institutions will be a key part of regulatory reform efforts. This was on the agenda even before the recent uproar about bonuses to derivatives traders at American International Group, but that controversy ensures it will have high priority.

What regulators are concerned about is that bonuses and other forms of compensation give incentives to managers and traders to take bigger risks than they should. What the current crisis has shown us is that traders are often rewarded for deals that later turn out to be disastrous for the company, long after those traders have pocketed their bonuses and even moved on.

The public backlash to the AIG bonuses and the lightning fast congressional response to it certainly brought home to Wall Street that things will be different. Particularly in large institutions, it seems clear there will be regulatory restrictions not only on the size of bonuses but on the acceptable reasons for the rewards. Federal Reserve chairman Ben Bernanke underscored the issue in a speech this week at a convention of community bankers in Phoenix. “Supervisors must pay close attention to compensation practices that can create mismatches between the rewards and risks borne by institutions or their managers,” he said. “Poorly designed compensation policies can create perverse incentives that can ultimately jeopardize the health of the banking organization.

Management compensation policies should be aligned with the long-term prudential interests of the institution, be tied to the risks being borne by the organization, provide appropriate incentives for safe and sound behavior, and avoid short-term payments for transactions with long-term horizons.” The issue has also figured in recent expert studies on regulatory reform. The report on regulatory reform released earlier this week by the head of the UK’s Financial Services Authority, Adair Turner, had a lot to say about executive compensation. Among its recommendations for reform, the Turner report called for codes of compensation among financial institutions to avoid incentives for excessive risk-taking. “There is a strong prima facie case that inappropriate incentive structures played a role in encouraging behavior which contributed to the financial crisis,” Lord Turner said in the report.

Last week, the Financial Stability Forum, which groups key central bank regulators, approved a report by Philipp Hildebrand, currently deputy governor of the Swiss National Bank and likely to succeed to the top job at the end of this year. The report does not recommend actual limitations on pay but says bonuses must not encourage bankers to take undue risks for which they cannot be later penalized. It says rewards should rather be based on long-term performance. Earlier, a report on regulatory reform for the European Commission prepared under the direction of Jacques de Larosière called for bonuses to be decided in a multi-year framework. They should be based on actual performance and not guaranteed in advance, the report said. It further recommended that supervisors have the authority to impose additional capital requirements in cases where firms did not observe proper compensation guidelines.

This report goes out of its way to mention that it is not talking about the eventual size of the compensation, though much of the public discussion has focused on that, but on the structure of the compensation and what kinds of incentives it provides. Likewise, the report says it is not referring to financial institutions that are receiving public aid during the current crisis and what responsibilities that may impose. “It is extremely important to re-align compensation incentives with shareholder interests and long-term, firm-wide profitability,” the report concludes. The Group of 30 report on financial reform prepared by a committee that former Fed chairman Paul Volcker chaired only referred in passing to oversight of compensation as part of improved corporate governance. But at the January press conference releasing the report, Volcker said that he thought compensation packages contributed to an excess of risk-taking on Wall Street. In any case, compensation is sure to be discussed as part of regulatory reform at the April 2 summit of the Group of 20 countries. Judging by the tenor of the various reports, the discussions will include guidelines for deferred payment of bonuses over a longer term and clawback provisions if transactions later turn sour.

Some of the congressional thinking on compensation issues is enshrined the Emergency Economic Stabilization Act that established the TARP program of bank bailouts last year. These provisions applied only to institutions that receive government funds for as long as any government debt or equity is on their books. They require the institutions to exclude any compensation that gives executives incentives to take unnecessary and excessive risks that threaten the value of the financial institution. There is also a clawback provision to recover any rewards that turn out to be based on earnings gains or other criteria that are materially inaccurate. There is a prohibition on golden parachutes, and an agreement to limit the tax deduction on the compensation for certain executives to $500,000. How much of all of this will actually make it into permanent new rules and regulations in the United States or other countries remains to be seen. How strict the final rules will be in the end may depend on how things evolve in the ongoing efforts to stabilize the banking system.

But the freewheeling glory days of annual compensation in the tens of millions of dollar that we have seen in the past couple of decades would appear to be history.