Views on improving the integrity of global capital markets
11 March 2011

Inviting Trouble

The U.S. Securities and Exchange Commission recently issued a draft of its proposed executive compensation rules. Like their regulatory brethren in the banking sector, the Commission was commanded by Sec. 956 of Dodd-Frank to impose new requirements on incentive-pay structures for financial institutions. While intended to help regulators determine whether pay arrangements create “inappropriate” risk or “excessive” pay, the new requirements call on regulators to become immediate experts on how and how much financial professionals are paid.

Making matters worse, the rules are not restricted to those sectors or institutions that were instrumental in the ’08 financial meltdown or were direct recipients of federal government bailout. No, the rules will require the Commission to review incentive pay at investment advisers, as well, to determine whether their incentive-pay packages cross some intangible Maginot Line and, therefore, are in need of revision.

Systemic risks, for sure, need tracking. But these new rules create as many questions about the systemic nature of compensation as it does about the ability of regulators to become experts in pay.

How will regulators determine what levels, or even what kinds of risks are inappropriate as a result of compensation arrangements? Will massive, leveraged concentrations in one segment of the economy be considered less inappropriate than an incentive-pay structure that rewards near-term trading profits? Similar questions arise about the distinctions about excessive pay. Will $4,999,999.99 be acceptable while $5 million is considered excessive?

Then there is the idea that regulators like the SEC, the Fed, FDIC, OCC, OTC, and National Credit Union Administration will be able to distinguish between those arrangements that are systemically problematic and those that are not. Given that many of these same regulators recently failed to prevent massive and systemic problems in areas where they have long-standing experience is not reassuring that they will succeed in this new endeavor.

The new rules for financial institutions with more than $50 billion in total assets are similar to requirements recently adopted in Europe. Here, senior executives of these big firms must defer at least half of their incentive pay over three years. In Europe, banks must defer between 40 percent and 60 percent of performance-based pay.

The U.K. market, therefore, has become a test case for the law of unintended consequences. They have added to the EU measures by limiting the amount of cash received for the remainder of bonus pay to 50 percent. Throw in a new 50 percent marginal income tax on current earnings, and the take-home portion of a bonus for London bankers would drop to just 10 percent, if that were how banks were handling things. However, the banks, in competition to pay to keep their top performers, have responded by increasing the amount of non-incentive, base pay. In some cases, the increases have been approaching threefold.

For decades, investors have strived to move executive pay toward a system based on real performance. Then, along comes a nexus of good-intentioned regulation and tax law that ends up breaking any link whatsoever between pay and performance.

Ultimately, the financial sector has to recognize that it helped create the situation where it now finds itself. It paid on short-term results, regardless of the long-term outcomes of the short-term actions. And it paid with abandon, even when everyone else was paying to keep it afloat. The new U.S. proxy access and say-on-pay provisions will help if investors take the time and effort to hold board members accountable.

So the industry left the door ajar, thus permitting policymakers to fill the void in both Europe and the United States. While we can’t expect our regulators to become overnight experts in pay, we can expect changes that will lead to unintended consequences.

About the Author(s)
Jim Allen, CFA

Jim Allen, CFA, is head of Americas capital markets policy at CFA Institute. The capital markets group develops and promotes capital markets positions, policies, and standards.

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