Navigating the Proper Course on Pay

Reports about new regulations on compensation practices at U.S. financial institutions emerged today in the Wall Street Journal.  Evidently, the Federal Reserve is working on new rules designed to reduce excessive risk taking such as incentives for mortgage loan production that fueled the current economic crisis.  Here is what was reported.

Among ideas being discussed are Fed rules that would curb banks' ability to pay employees in a way that would threaten the "safety and soundness" of the bank -- such as paying loan officers for the volume of business they do, not the quality. The administration is also discussing issuing "best practices" to guide firms in structuring pay.

Government officials said their effort, which is just beginning, isn't aimed at setting pay or establishing detailed rules. "This is not going to be about capping compensation or micro-management," said an administration official. "It will be about understanding what is the best way to align compensation with sound risk management and long-term value creation."

Solid corporate governance practices and effective risk management programs should be enough to limit excessive risk taking through well designed compensation plans.  However, it seems the U.S. Government is not convinced that companies will navigate the proper course.

 

Turning a Blind-eye Toward Risks

For those of you who have been following The ERM Current,  you may recall the post "Show Me the Money and I'll Show You the Risks".  In that post, the main advice centered on the need to examine incentive structures to determine where excessive risk-taking may be occurring.  As the current financial crisis continues to unfold, the excessive risk-taking driven by grandiose incentives is becoming more and more evident.  Yesterday, the New York Times featured an article on this very topic.   Below is an excerpt from the article,

“Compensation was flawed top to bottom,” said Lucian A. Bebchuk, a professor at Harvard Law School and an expert on compensation. “The whole organization was responding to distorted incentives.” Even Wall Streeters concede they were dazzled by the money. To earn bigger bonuses, many traders ignored or played down the risks they took until their bonuses were paid. Their bosses often turned a blind eye because it was in their interest as well.  “That’s a call that senior management or risk management should question, but of course their pay was tied to it too,” said Brian Lin, a former mortgage trader at Merrill Lynch.

To be effective, risk management must have the authority and the independence to adjust incentive programs based on the risk appetite of the organization.  If risk managers are participating in the very incentive programs that they are charged with overseeing, then a blind-eye will always be turned toward excessive risk-taking.