Bankers' Compensation: Two Ideas for Influencing Bankers, Empowering Investors

On Wall Street, bankers continue to speculate about a government role in their future compensation. Although policymakers shelved the issue during the health care showdown in the United States and the Greek debt crisis in Europe, that suspension is likely to be temporary. Seldom have the heads of the world’s leading economies demonstrated such unanimity of opinion on a controversy. President Obama expressed disgust over bankers’ bonuses. In London, City Minister Paul Myners, called “grotesque” the news that 5,000 London bankers would receive bonuses of 1 million pounds. French President Nicolas Sarkozy received widespread applause at Davos when he stated that pay packages that “bear no relationship to merit” are “morally indefensible.” The scrutiny and torrent of criticism is bound to reemerge, as New York officials reported that Wall Street bonuses grew 17 percent in 2009 to surpass $20 billion. Rarely has any economic issue been better suited to populist political rhetoric.

The frustration and outrage from government officials and citizens over bankers’ compensation is understandable. The urgent feeling that there should be some penalty for irresponsible behavior at leading financial institutions, especially those that received government bailouts, makes sense on an emotional level. But governments would be better off focusing their attention on enabling parties with more permanent and direct interest in the performance of banks and other financial services firms—shareholders and investors—to promote more responsible executive compensation policies. Two mechanisms, a binding say on pay for bank leaders and an institutional investors’ code of conduct, offer vehicles for a substantive discussion. Open dialogue among policymakers, investors, and leaders in the financial community has the potential to yield policy prescriptions that influence bankers’ behavior appropriately without upsetting the profit logic that rules in an industry essential to a global economic recovery.

First, consider a say-on-pay rule. The basic framework for this policy is already in force in multiple European countries and under discussion in the U.S. Congress, and could be modified to account for the unique role of banks. Putting bank leaders’ pay to a binding shareholder vote would provide transparency on compensation packages and give a measure of control to the people who have the most at stake—the owners of the business. Such a policy would also be far easier to harmonize worldwide than those relying on changes in tax codes. Policymakers should discuss the notion if only because it represents a practical and substantive policy option, more lasting than angry sound bites.

There is room for discussion in Washington, London, and other capitals about how to implement a say-on-pay vote. One possibility: empower shareholders to vote on the size of a bank’s bonus pool as a percentage of some measure of profitability. Other ideas to discuss: banks could stipulate that an independent executive compensation consultant endorse pay packages as being consistent with some set of “generally accepted compensation principles,” equivalent to opinions offered by audit firms. Those “endorsed” plans could then be submitted to a shareholder vote or shareholders could vote up or down on all payment packages that are above a certain absolute level.

However, implementing a say-on-pay rule for the compensation of highly paid bankers could hurt the affected banks by making them less attractive employers. Instead of working at a bank where their salaries are open to binding votes, talented financial managers might depart for private equity firms and hedge funds. Such adverse selection would impair the recovery of leading banks, undermining their ability and willingness to lend, prolonging the economic downturn.

The negative effect of a say-on-pay rule demonstrates the difficulty of translating populist rhetoric into durable policy. For if governments want to curb bankers’ pay, they must devise a mechanism that accounts for the large percentage of financial activity, such as securities trading, that takes place in either private firms or public entities not currently subject to banking regulation. Any policy to curb compensation in “too big to fail” banks must impose some equivalent discipline on a far broader range of financial institutions.

It’s difficult to envision how government could impose such a policy, but political leaders could encourage the adoption of an institutional investors’ code of conduct. Institutional investors such as insurance companies, university endowments, and public and private employee pension funds, could agree to encourage responsible behavior. If a number of large institutions stipulated that they were not going to invest in any entity that refused to embrace the principles outlined in such a code, others would follow. Such a code of conduct could follow accepted rules on executive compensation, in addition to other matters such as fees charged for services. No doubt some private fund managers would balk at following such demands. But a principled stand would have the potential to impose some discipline on the market for executive compensation.

As for the bankers, they must weigh whether they prefer the tender mercies of the court of public opinion or an annual dialogue with their shareholders or limited partners. Just “saying no” is unlikely to be enough.

About the Author: Joseph Fuller is a co-founder of Monitor. A highly respected speaker and author, his work has appeared in The Wall Street Journal, the Financial Times, The Washington Post, Sloan Management Review and Harvard Business Review.