A TOOTHLESS APPROACH TO REINING IN EXCESSIVE EXEC PAY
By Eleanor Bloxham, contributor
FORTUNE — Even though the banks that managed to survive the financial crisis have largely mended their own balance sheets, they are far from out of the doghouse with regulators. Reports circulated last week that New York attorney general Eric Schneiderman’s office is expanding its probe of bank mortgage operations, which already consists of the likes of JPMorgan (JPM), Deutsche Bank (DB), and UBS (UBS). To comprehend the motivations at the banks that has paved the path to this probe, we require look no further than how the banks pay their executives.
Whatever changes monetary institutions may possibly have made to their risk oversight and compensation programs have been inadequate. That is clear just from the error-riddled foreclosure processes, which dragged on unimpeded (without even apologies until recently), causing several crisis aftershocks.
“State attorneys general told five of the nation’s largest banks on Tuesday they face a prospective liability of at least $17 billion in civil lawsuits if a settlement isn’t reached to address improper foreclosure practices” a “figure [that] doesn’t cover further billions of dollars in potential claims from federal agencies,” the Wall Street Journal reported on Wednesday.
While there’s been lots of talk from banks and regulators, there is been far much less action to establish positive footing in the risk and compensation arenas at these institutions.
The slow pace of alter began right right after the financial crisis engulfed the banks. President Obama appointed a pay czar (Ken Feinberg), and while caps on pay were instituted, none of the banks delivered any meaningful systemic change. The banks that received TARP funds were obligated to talk about their compensation programs in SEC filings, explaining how their practices did not encourage excessive risk. But rather than in fact alter compensation, bank compensation committees typically relied on workers inside the bank (i.e. risk management personnel) to bless their existing plans.
Having internal workers approve compensation plans will not do much to alter anything other than make a few individuals unwittingly feel better. What is a risk management person going to say to the CEO who signs his paycheck: “yours is too big, especially for the risk you’ve taken on”?
But, a proposed multi-agency rule, which includes the Office of the Comptroller of the Currency, Federal Reserve, FDIC, National Credit Union Administration, SEC and the Federal Housing Finance Agency, would mandate that risk management personnel be involved in the development of banks’ compensation plans.
Granted, this requirement is just one of numerous within the proposed rule, but it’s a weak response to a issue that is bigger than the regulators seem to comprehend. Comments on the multi-agency proposal close at the end of May possibly, and since the issues are so critical, regulators require to take a second look.
What is suitable pay, anyway?
The proposed rule would call for monetary institutions to develop a report that outlines “the particular reasons why … the structure of its incentive-based compensation strategy does not encourage inappropriate risks.”
But what is inappropriate to you or me may possibly appear really suitable to the bank next door. And internal management risks too frequently go unidentified and all compensation programs have their risks.
Regulators want to get financial institutions to identify their own internal management risks, how their compensation programs will ameliorate, rather than amplify, those risks, and why those remedies (as opposed to alternatives) are the best approach.
Perhaps if financial institutions had gone via this physical exercise right away soon after the crisis, some of the foreclosure mess might have been avoided. Banks would have identified paperwork risks and ensured that the good quality of processes mattered as considerably, if not a lot more, to their workers than the speed of processing.
Also, regulators need to have to recognize that all compensation programs come with risks. Pay too small and you will have trouble hiring best talent. Pay too significantly, and for the wrong points, and you will attract candidates, but not ones with proper motivations. So instead of pretending compensation programs do not produce risk in some form, regulators really should recognize that all programs do. The question to be addressed, nonetheless, is no matter whether a bank understands its own programs well enough to identify and reduce the risks.
The allure of giving yourself a raise
Income can be addictive, just as power and drugs and alcohol and chocolate can be. And excessive compensation can be a potent drug, leading to all kinds of unwanted behavior (See: Rajat Gupta).
The proposed rule would require banks to assess no matter whether or not its compensation is excessive. One of the tests to figure out whether or not a bank is giving out excessive compensation would be to examine what peer banks pay their executives. But if everybody is earning vast sums and taking great risks as a result, it doesn’t mean that pay is on target. (Other metrics can be beneficial. See “How can we address excessive CEO pay?”)
Excessive compensation can also be monitored based on whether or not a bank is making lengthy-term economic value, for the bank itself and for its shareholders, workers, clients, and other stakeholders. That would involve measuring the lengthy-term risks versus the rewards of a bank’s financial decisions.
While the proposed rule encourages financial institutions to measure their companies based on the risks they assume and use those measurements in their compensation, they need to mandate it instead. Monetary institutions are in the company of trading risk for reward. If a manufacturing firm didn’t measure its costs but only its revenues, you’d know some thing was amiss. The identical holds true for banks.
How do corporate boards fit in?
The requirements related to the role of the board need to be strengthened under this rule. For example, the proposed rule suggests that boards ought to obtain data to perform its compensation oversight but does not offer clear guidance on the kinds of data boards ought to receive.
In addition, the proposed rule says the “board of directors, or a committee thereof, need to review and approve the overall goals and purposes of the … incentive-based compensation method and guarantee its consistency with the institution’s overall risk tolerance.”
The mindset of “review and approve” is 1 of rubber-stamping, the last factor regulators really should be encouraging from boards of directors at financial institutions.
No time for a rushed job
The proposal aims to have its requirements implemented within a six-month period. Whilst it is critical to move rapidly, regulators ought to heed the admonition “measure twice, cut when” if they desire real alter. Now is not the time for rushing but for careful thinking about a sustainable strategy. Now is the time to seriously address risk and compensation at monetary institutions. The foreclosure crisis has shown that the status quo is untenable. The way forward will demand real work.
Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance (http://thevaluealliance.com), a board advisory firm.