Washington looks at making compensation permanent part of financial regulation

Executive compensation has been the big issue in Washington this week.

First, 10 of the biggest takers of the government’s bank bailout funds got permission to pay back that money and free themselves from restrictions on bonuses imposed by Congress for institutions that have bailout money.

But the administration also designated a new “compensation czar” to oversee pay at the top seven firms that remain on life support from the government, including Citigroup, Bank of America and American International Group.

Amid all the compensation headlines, though, media tended to lose sight of a more fundamental reform now under way in Washington that will permanently alter pay practices at financial institutions.

The administration and Congress are looking at ways for regulators to supervise pay practices at financial firms that will go beyond basic reforms in corporate governance for firms in general, such as “say on pay” provisions for shareholders or more independent compensation committees.

On Wednesday, Treasury Secretary Timothy Geithner, while saying that the administration would not seek to cap executive pay, laid out some of the principles that will guide the government’s thinking.

A hearing on Thursday before the House Financial Services Committee brought further discussion of the issue as it applies to financial institutions, with representatives from the Treasury Department, the Federal Reserve, and the Securities and Exchange Commission joining outside experts to testify about “Compensation Structure and Systemic Risk.”

A consensus has grown in Washington that compensation incentives based on short-term profit encouraged excessive risk taking at banks and played a major role in creating the financial crisis.

“This financial crisis had many significant causes, but executive compensation practices were a contributing factor,” Geithner said in his statement on Wednesday. “Incentives for short-term gains overwhelmed the checks and balances meant to mitigate against the risk of excess leverage.”

The industry has not argued with that position and has pledged to better align incentives to long-term goals.

But it became clear this week that neither the administration nor Congress will rely on the good faith of the institutions alone to handle the issue.

Harvard law professor Lucian Bebchuk said that government supervision of bank compensation should last well beyond the bailout. Banks are different than other companies, he said, because the government insures their deposits and stands ready as lender of last resort to preserve the functioning of the financial system.

“Because the setting of pay arrangements can…have substantial consequences for the risks posed by a bank to the government and the economy, banks’ regulators should going forward also monitor and regulate the structure of executive compensation in banks,” Bebchuk said in his written testimony. “Regulation of executive pay should be an important element of banking regulation in the new financial order, and should remain so long after no banks remain publicly supported.”

Bebchuk, who co-authored a 2004 book with Jesse Fried entitled Pay Without Performance: The Unfulfilled Promise of Executive Compensation, has the ear of the administration. Gene Sperling, the former Clinton administration economic adviser now serving as counselor at Treasury, cited Bebchuk’s academic work in his own testimony Thursday.

Awarding common stock – even restricted stock that would delay when executives could cash it out – does not necessarily work in banks, Bebchuck said, because of the leverage built into banking, including government-guaranteed deposits. Shareholders themselves often stand to benefit from excessive risk-taking, so just aligning executives’ interests with shareholders does not solve the problem.

“This is because the shareholders’ interests could well be served by the taking of risks that are detrimental to the government’s interests as preferred shareholder and guarantor of some or all of the banks’ debt.” Bebchuk said.

Rather than just linking an executive’s pay to common stock, it would be better to tie it to a specified percentage of the aggregate value of the common shares, the preferred shares, and the bonds issued by either the bank holding company or the bank, Bebchuk argued. Treasury’s Sperling echoed him on this point.

In his remarks on Wednesday, Geithner sketched some broad principles for executive compensation, especially in the financial sector:

• Compensation plans should properly measure and reward performance. Compensation practices that set the performance bar too low or rely on benchmarks that trigger bonuses even when a firm’s performance is subpar undermines the whole concept of incentive pay.

• Compensation should be structured to account for the time horizon of risks. Companies should seek to pay top executives in ways that are tightly aligned with the long-term value and soundness of the firm.

• Compensation practices should be aligned with sound risk management. Compensation committees should conduct and publish risk assessments of pay packages to ensure that they do not encourage imprudent risk-taking.

• Golden parachutes and retirement packages need to be reexamined. Too often they provide severance packages that do not enhance the long-term value of the firm.

• Transparency and accountability in the process of setting compensation should be promoted. Many of the compensation practices that encouraged excessive risk-taking might have been more closely scrutinized if compensation committees had greater independence and shareholders had more clarity.

“We are not capping pay,” Geithner stressed. “We are not setting forth precise prescriptions for how companies should set compensation, which can often be counterproductive. Instead, we will continue to work to develop standards that reward innovation and prudent risk-taking, without creating misaligned incentives.”

Rules will evolve, Geithner indicated, as regulators monitor the impact of steps taken. The President's Working Group on Financial Markets will conduct an annual review of compensation practices to see whether they are creating excessive risks, he said. BREAK

Scott Alvarez, general counsel at the Fed, explained in his testimony at the Thursday hearing why regulators needed to drive this process.

It is difficult for an individual firm to take the initiative to correct misaligned incentives, he said.

“Even if the owners of an individual firm do not like the way compensation is structured at their firm, they may be unwilling to make unilateral changes because doing so might mean losing valuable employees and business to other firms,” he said.

Regulators can play a constructive role in counteracting these forces, Alvarez said. They can press all financial institutions to adopt sound practices that don’t provide inappropriate incentives, but that individual institutions might be wary of adopting alone.