It is now well acknowledged that incentive arrangements skewed towards short-term returns that faced bankers, fund managers and traders played a critical role in inflating the sub-prime bubble and causing the deepest economic recession since the Great Depression. Accordingly, all recent efforts at regulatory reforms to impose greater oversight on the financial markets have sought to place curbs on executive compensation.
However, nothing substantial has till date been legislated or decreed into action. In the circumstances, the French government has taken the lead by concluding an agreement with the leading banks to limit executive compensation. It was agreed that up to two-thirds of bonus payments should be deferred for three years, while a third should be paid in shares of the bank. It was also agreed that the bonuses would be paid out based on the performances of the bank as a whole and not that of particular trading desks.
However, the French decision will not be sustainable without similar strong action in other countries, especially across the Atlantic. In the absence of co-ordinated action of similar kind across the major economies, the holdout economies will benefit as they will end up attracting more financial activity and the better bankers. This assumes even greater significance, in view of the disturbing signals on "business as usual" emanating from the US.
Economists like Lucien Bebchuk have called on governments to take on the role of monitoring and regulating pay in financial firms, failing which the perverse incentives that contributed to the current crisis could easily recur. In a recent article he argued that compensation-induced incentive distortions will apart from going against shareholder interests, also produce incentives for excessive risk-taking that imposes unacceptable costs on the society and economy at large. However, instead of micro-managing by imposing quantitative limits on payments, he prefers "regulatory standards that could require equity-based plans to preclude managers from cashing out awarded shares and options during a certain minimum period after vesting".
Update 1
Eric Dash lists out the possible reasons for the mis-alignment between Wall Street pay and risks taken.
Update 2
Switzerland joins France with its own, albeit watered down version of limits on executive compensation. While there were no caps on bonuses, high-level executives are to have a significant part of their pay deferred for a minimum of three years to insure it is better linked to risk. It also requires that the bonuses "actually have been earned by the company over the long term". It also excludes all but the country’s biggest financial services companies from mandatory compliance.
Update 3 (23/3/2010)
Times reports that of the 104 senior executives whose pay was set by the federal pay regulator in the last two years, 88 executives, or nearly 85 percent, are still with the companies even though their pay was drastically cut back. This flies in the face of fears that lower executive compensation would lead to top executives fleeing firms in droves.
Update 4 (13/7/2010)
The European Parliament approves tough limits on bankers’ bonuses. Under the new rules, bankers will receive only 20-30% of their bonus in upfront cash. Banks must defer payment of 40-60% of bonuses for 3 to 5 years. And half of a banker’s upfront bonus must be paid in shares or 'contingent capital' — bonds that convert into equity if the bank gets in trouble. The rules allow for banks to claw back bonuses paid to executives whose investments are initially profitable but go awry a few years down the road.
Alex Edmans points to AIG's recently announced proposal that 80% of their executives’ bonuses will depend on the price of their firm’s bonds and only 20% will depend on the price of their equity, and argues that "such moves will better align CEO fortunes with those of all investors – both shareholders and bondholders – and help prevent future financial crises".
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