The Obama administration has retreated from strict curbs on Wall Street pay, even at banks still on TARP life support. But the ‘say on pay’ bill in Congress the administration is now supporting could have disastrous consequences of making bankers even more eager to take financially irresponsible risks that could push the entire financial system back to the brink of destruction.
The ‘say on pay’ bill before Congress seeks to give shareholders a voice to approve or disapprove compensation packages for top executives. It would also attempt to make the compensation committees on corporate boards more independent. But these changes could have the perverse result of pressuring bankers to take on even more risk in search of profits to justify their giant paychecks.
The history of regulating pay isn’t pretty. The Clinton-era reforms removed the tax deductibility on executive salaries over $1 million, which led companies to switch to paying executives with huge stock option packages. Since options increase in value with the volatility of the
underlying stock, executives responded by taking actions to increase risk. And, famously, it helped bring us the big backdating scandal.
The unintended consequence of ‘say on pay’ will likely be very similar. It is very hard for investors to monitor firms with complex and speculative sources of revenue such as banks. Investors can see short-term returns, but they do not understand very well how those returns are generated. Very often banks—especially investment banks—disclose very little about how they are making money.
When times are good, banking executives can demand higher and higher paydays. But as these eat into investor returns, the stock price tends to stagnate. In order to justify still higher paydays, executives take on more risk to justify their pay. Adding additional pressure of shareholder votes will only further feed this dynamic, giving managers another incentive to take on risk to justify their pay.
Something like this already seem to be underway at Goldman Sachs, which generated huge returns by increasing its risk taking last quarter. For all we know, Goldman might be able to manage this kind of risk taking. But do we want to adopt a compensation reform that once again sets the entire financial sector on the hunt to be more like Goldman?
It seems very likely that ‘say on pay’ will only accelerate risk mispricing caused by self-dealing executives. And this is a straight line toward crisis.
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