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Pay restrictions may not fix underlying risk-taking

By Steven Pearlstein
Friday, October 23, 2009

With financial markets booming even as Main Street is still largely mired in recession, policymakers in Washington on Thursday were scrambling to contain growing populist anger by proposing new rules to curb runaway pay on Wall Street.

Treasury pay czar Ken Feinberg ordered big cuts in base salaries and perks at General Motors, Citigroup and a handful of other firms that were kept alive only through the government's extraordinary intervention. More significantly, the Federal Reserve proposed a set of broad new regulations to reduce the kind of reckless risk-taking at regulated banks caused by "heads I win, tails you lose" compensation schemes.

All this is fine as far as it goes, but don't get carried away. By themselves, these measures won't prevent future crises, nor will they likely do much to lower the prevailing pay levels on Wall Street or in corporate America.

Much of the damage during the recent bubble was done by traders and executives who had plenty of skin in the game and lost their jobs, their reputations and virtually all of their considerable fortunes when it all came crashing down. It's hard to argue they lacked sufficient incentives to be more careful with the risks they were taking.

At the same time, there is also an irreducible asymmetry in any performance-based compensation scheme that makes it difficult to perfectly balance risks and rewards. When markets are hot and things are going well, the sky's the limit in terms of how big a bonus you can earn. But when profits suddenly turn to dramatic losses, the lowest a bonus can reach is zero. Banks can retain some rights to claw back bonuses from previous years by delaying the payout for a few years, but once the money is actually paid, it's pretty hard to get it back.

Public coffers

The pay issues get even more complex when taxpayer money is involved.

Consider the case of Citigroup, which last year was bailed out by the Treasury to the tune of $45 billion. For all its problems, the one bright spot at Citi has been its energy unit, Philbro, which over the past five years has earned roughly $500 million a year in pretax, pre-bonus trading profits. Under his contract, Andrew Hall, Philbro's head trader, is reportedly entitled to a bonus of roughly $100 million this year, but with taxpayers now owning roughly 40 percent of the bank, such a payout is politically unacceptable. When Feinberg indicated he would not approve the bonus and Hall threatened to walk, Citi reluctantly concluded its best option was to sell Philbro to Occidental Petroleum for the bargain price of $250 million.

To many on Wall Street, this seemed like a ridiculous outcome: Hall will still get his $100 million bonus, while self- righteous taxpayers are left with 40 percent stake in a less profitable Citigroup. But looked at another way, this may be just the sort of restructuring that the financial sector needs, and that regulators now mean to encourage.

Long-term thinking

The central tenet of the Fed's new pay rules is that banks must adjust performance bonuses for traders and executives to reflect the long-term risks that they are taking. If Trader A earns a million dollars for the bank by trading highly rated bonds in highly liquid markets, while Trader B earns the same million speculating in derivatives that are riskier and thinly traded, then under the Fed's regime, A's bonus ought to be a lot bigger than B's.

That might work out just fine if derivatives trading were done only at regulated banks. But if derivatives trading is also done at unregulated hedge funds or even corporations such as Occidental Petroleum, where there are no restraints on performance pay, then the bank is likely to find itself at a serious disadvantage in attracting and retaining the best derivatives traders.

The big banks, of course, will make precisely this argument as they seek to water down the Fed's pay proposal, just as they will try to water down similar proposals to require them to hold more capital or use less leverage. Their complaint will be that if they compete on an uneven field, they will inevitably lose talent, capital, market share and profits.

They may be right, of course, but if it turns out that these pay rules wind up steering the riskiest activity to smaller, more focused institutions whose failure won't require them to be bailed out by the taxpayer, that might be a good thing.

After all, we know what happened when the button-down commercial bankers were let loose a decade ago to start competing with, and behaving like, investment bankers. And we can be pretty sure what will happen in the future if Citigroup, J.P. Morgan Chase and Goldman Sachs continue down the path of competing with, and acting like, hedge funds.

So does Andrew Hall really "deserve" his $100 million? From an economic standpoint, that remains an open question. What's not in doubt, however, is that for every Andrew Hall there's a Brian Hunter of Amaranth Advisors and John Meriwether of Long Term Capital Management, equally brilliant traders who took big risks, earned big money, got unlucky and wound up losing it all. An open, vibrant and innovative financial system ought to have a place for all of them. But that place is not in a regulated bank that everyone knows is too big to fail.

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