As we mentioned earlier today, the long-simmering issue of executive pay is getting tacked onto the debate about the Hanke-Panke (Hank Paulson-Ben Bernanke) Wall Street bailout. Quite understandably, lawmakers want to ensure executives at firms whose troubles have placed the entire financial system at risk and now require taxpayer money to bail them out won’t continue to receive enormous paychecks or walk off with eye-popping 8 or 10 figure severance payments.
But a pay cap could have perverse effects on the markets. If accepting government largesse is contingent on pay caps, executives will likely be hesitant to participate in the bailout plan. This might seem irrational—it requires us to believe that executives would rather endanger their firm than accept lower pay—if not for recent events. Just look to the example of Dick Fuld, the Lehman Brothers chief who resisted allowing all or part of his firm to be acquired right into bankruptcy. Throughout our current crisis, Wall Street executives have tended to be overconfident about the financial health of their firms.
What’s more, executives often put their own welfare ahead of that of shareholders. Economists like to call this an ‘agency cost.’ The various techniques to minimize agency costs by aligning their interests with shareholders have focused on making sure the executives profit only when they increase shareholder value. A deal that trades pay caps for bailout bucks breaks this alignment by penalising executives for accepting funds that would bolster their firms’ financial health.
Still worse, pay caps could drive talented executives out of the troubled financial firms. Industries unaffected by the pay caps would benefit from the influx of talented people, while those saddled with them would suffer even further. It’s tempting to say that we’d be better off without these so-called ‘talented’ Wall Street types and that things couldn’t get worse. But that’s wrong: things can get worse.
There’s no readily available solution to these problems. If the pay cap were extended beyond those firms accepting bailout bucks to all financial firms in order to eliminate the disincentive from participating in the bailout, talented people would be driven from finance altogether. If it were extended to all public companies, talented people would flee public companies. Hedge funds, for instance, would benefit enormously. The already underway drift from publicly held corporations to closely held partnerships would be greatly accelerated. What ever you think of this drift, it surely is dangerous for lawmakers to stamp on the accelerator, driving us into this little explored territory before the markets have mapped it out.
Still, allowing executives whose firms are propped up by taxpayer dollars to keep their Greenwich mansions and enormous wealth is a hard pill to swallow. The most radical proposal involves a clawback of executive pay, forcing executives who led us into this mess to give back at least part of the fortunes they accumulated while the going seemed good.
“It’s time to start talking about a clawback provision as the grounds of any bailout,” Barry Ritholtz writes today. “If every man woman and child in the USA is going to be on the hook for a Wall Street Incompetence Tax of $5-10k each, then the folks who brought us this mess, and took bonuses under the false pretense that the profits they generated were real, should also shoulder some of the costs.”
While deciding who should pay how much seems like a task fraught with imponderables, this would at least have the benefit of penalising those who brought us into this mess without creating major distortions for the future.
Business Insider Emails & Alerts
Site highlights each day to your inbox.