The Real Problem Still Looms Large

This week, the New York Times reported that the Federal Reserve is completing a comprehensive review of incentive programs at the nation's largest financial institutions. The findings are surprising given the role of the incentive programs in igniting the financial meltdown of 2008.  Here's what the Federal Reserve has discovered.

The Federal Reserve, six months into a compensation review of the country’s 28 largest financial companies, has found that many of the bonus and incentive programs that economists say contributed to the worst financial crisis since the Great Depression remain in place, according to people briefed on the examinations.

Officials have found, for example, that risk managers at several of the biggest banks still report to executives who have influence over their year-end bonuses and whose own pay might be constricted by curbing risk. In many cases, risk managers do not have full access to the compensation committee of the banks’ boards.

The review also revealed that banks tend to set similar bonus formulas for broad sets of employees and often do not adjust payouts to account for risks taken by traders or mortgage lending officers. Bank executives and directors, meanwhile, are often in the dark on the pay arrangements of employees whose bets could have a potentially devastating impact on the company.

This disconnect between pay practices and risk taking is at the heart of the problem and must be resolved for financial institutions to thrive in the long-term. It starts with having a strong enterprise risk management infrastructure and framework as a foundation for addressing the major disconnects between the board, bank executives and line management. Then, financial institutions must begin to faithfully utilize risk-adjusted performance metrics to drive their pay practices. Until this happens, no amount of governmental regulatory reform will solve the real problem behind the financial crisis.

New Rules on Pay Practices

This past weekend reports surfaced about new rules on limiting executive pay at financial institutions that received taxpayer assistance. The rules are expected to be promulgated by the U.S. Treasury as reported by Reuters below.  

Treasury Secretary Timothy Geithner is expected to issue rules as early as next week on how bailed-out banks must limit their executives' pay. He is also working on ways to reform the compensation practices of the entire banking industry to discourage a focus on short-term gains and undue risk-taking.

Lucian Bebchuk, a professor at Harvard Law School, and colleague Holger Spamann argue that a banker's pay should be tied to all of the bank's assets, not just to equity, which they say accounts for only about 5 percent of overall assets.

"Banking regulators should monitor executive pay in banks, and prevent arrangements that incentivize top bankers to focus only on the bank's equity, which ... can gain through strategies that are detrimental to the other 95 percent," they write in a forthcoming paper.

Bebchuk and Spamann suggest top bankers should be paid on a "broader set of claims, including deposits and junior debt," which would prod them "to place much greater weight on possible losses in their choice of strategy."

These new rules on executive pay most likely will serve as extra incentive for financial institutions to return taxpayers' money as opposed to lasting changes in pay practices. True changes must emanate from within the financial institutions' corporate governance structure beginning with pressure from the boards of directors.