Questions of equity
Salary caps are a rotten idea; but the crisis also carries lessons for regulators and workers.
IT IS easy to understand why many in Congress and beyond have demanded salary caps on bank executives as a condition of approving the Bush administration’s bail-out of the financial system. After all, many of the people who will be leading the effort to get the banks back on their feet were the very same masters of the universe whose greed and myopia brought the industry to its knees in the first place. Nonetheless the lawmakers’apparent decision to impose some form of still unspecified wage limit, a demand reluctantly accepted by Hank Paulson and the Bush administration this week, is a mistake.
Just now, it is a struggle to keep a straight face when you read the words “talent” and “Wall Street”in the same sentence. And yet, precisely because it is in a mess, the financial system will need decent managers if it is to return to the health that benefits the rest of the economy. The sort of sums that would satisfy Congress as a cap may be far above the incomes of average Americans, but there is no surer way of driving finance offshore or into hedge funds where it is beyond the gaze of regulators. Besides, if ever there was a time when pay in banking and broking is likely to be depressed by the market, it is now. The bubble did not only inflate asset prices, it also inflated pay. Now the bubble has burst and hundreds of thousands of finance professionals want work.
American politicians have a lamentable record of intervening in setting executive pay. In the early years of the Clinton administration, Congress imposed a salary cap of $1m, beyond which firms faced a tax penalty. Pay rose, as one set of executives, beneath the cap, realised that they were “underpaid” and another set gained from an outpouring of creativity, as consultants invented myriad option schemes, perks and pension benefits to get around the limit. This only made it harder for shareholders to know who was getting what.
If the foolishness of Congress setting corporate pay levels is an old lesson, the financial crisis is teaching some new ones to shareholders. First, forget the received wisdom that paying people in large amounts of shares in their own firm ensures they take sensible value-maximising decisions. In the collapse of Lehman Brothers and Bear Stearns, the management did not just take reckless gambles with other people’s money. Dick Fuld and Jimmy Cayne took reckless gambles with their own-and still they failed to do the right things and ended up losing most of their fortunes. Outside shareholders should remember that loading up the people at the top with shares can be an aid to corporate governance, but not a substitute for it.
For employees, the tale of Lehman, especially after Enron, is a reminder of the danger of having too many savings tied up in the firm where you work. More of the truly talented will now demand their bonuses in cash, or perhaps ask for even more shares. That surely will have an effect on the way that firms recruit staff and on employee share-ownership schemes. Paying ordinary workers in shares is expensive-because equity is costly to issue and discounted by employees. And the idea that ordinary workers who own shares in their firm will stop senior managers taking bad decisions has taken another knock.
The structure of bonus schemes is more important than their level-especially in finance. Foolish short-term risk-taking could be discouraged by matching the timing of bankers’ pay to the timing of the risks they are trading. Britain’s Financial Services Authority may ask banks to put up more capital if their pay structures are dangerously risky. That makes far more sense than capping pay. But in the end companies and shareholders are better at setting salaries than bureaucrats.