Regulating emoluments with claws

Should the government be in the business of fixing the salaries and bonuses of private sector bank employees? An intense debate is raging on this issue in Europe and the US. On one side are diehard free marketers who are against any government intervention even in a sector that has received billions in bailout over the past year and due to the bailout, governments in Europe and the US own substantial stakes in many banks and financial companies.

On the other side are those who argue that last year���s global financial crisis was caused by the outrageous compensation practices that provided executives high incentives for taking unwarranted risks. These compensation packages included high reward for short-term profits, but no punishment for losses. To avoid future financial crises, it is argued that governments should regulate the compensation packages of bankers so that they are not rewarded for taking excessive risks and governments should ���claw back��� bonuses in the event of poor performance.

Despite the intense debate and public outrage, executives in banking and investment companies that were bailed out by tax money last year have continued to receive outrageous salaries and bonuses. In July, the New York attorney general Andrew Cuomo���s office reported that financial firms that received federal bailout paid more than 5,000 employees over $1 million each in bonuses in 2008. But for the bailout money, it seems, many of the banks may not have been able to pay multi-million bonuses to their employees. The saga of banking excesses is continuing in 2009. The Wall Street Journal recently projected that in 2009 the US banks and securities firms will pay $140 billion in bonuses and salaries ��� an all-time high.

Political response to big bonuses has not been uniform on both sides of the Atlantic. Politicians in Europe have been more proactive in taking on big banks and investment companies. At the G-20 meeting in Pittsburg last month, all the 27 EU nations supported global rules for restraining bank bonuses that included deferment of a major part of the bonuses and possible cancellation in the event of poor performance.

In France, at the intervention of President Nicolas Sarkozy in August, France���s biggest bank BNP decided to hold back half the bonus for three subsequent years. Last week, the top five banks in the UK also agreed to tighter control on bonuses with assurances from the government that foreign banks in the UK would be subject to same rules.
Politicians in the US, on the other hand, have been reluctant to intervene. While expressing outrage at the huge bonuses being awarded to bank employees, even democrats are hesitant in advocating any measure that would put caps on salaries and bonuses lest they are perceived as enemies of free enterprise or as meddling too much into the economy. Barney Frank, chairman of the House Financial Service Committee, one of the most vocal advocates of reforming and regulating the banking industry, recently argued that the government should not determine the pay levels of bank employees.

In a recent interview to Bloomberg News, President Obama too questioned the case for limiting financial-sector pay. Obama argued that executive compensation for Wall Street bankers should not be capped for the same reason that the Silicon valley entrepreneurs do not face any such salary cap. The US President missed a small detail in comparing the technology sector with the banking industry. When Silicon Valley entrepreneurs lost billions in the stock market with the bursting of the dotcom bubble a few years ago, the government did not come to their rescue. Banking industry is different. The government cannot allow banks to fail because such a failure is likely to shake public confidence in banking industry in general, that can potentially lead to the collapse of the banking and financial sector worldwide.

To be fair, the Obama administration has taken a number of steps to limit executive compensation at financial institutions that have received bailout money. In July, the US House Financial Services Committee approved a bill that allowed shareholders to vote on pay packages. The Bill also gave regulators the authority to prohibit inappropriate or risky compensation practices by banks and other financial institutions. Unfortunately, it does not seem that shareholders are using their powers. Take the case of Bank of America. It incurred a loss of $3.2 billion in the most recent quarter, but its employees received a hefty $13.2 billion in compensation and the share holders did nothing about it.

The Obama administration has also appointed Kenneth R Feinberg as the pay czar to oversee the compensation of employees at companies receiving billions in federal assistance. According to news reports, Feinberg has broad discretion to determine the salaries and bonuses of the five most senior executives and 20 most highly paid employees at each of these companies.

However, it appears that there is little political will in the US to restrain the salaries of employees in the financial sector. Instead, the pressure to curtail salaries and bonuses of bank employees appears to be coming from the Federal Reserve. The Fed is considering imposing rules that require banks to ���claw back��� bonuses in the face of losses and link pay to long-term rather than short-term performance. The Fed has argued that it has the authority to impose this rule as part of its general mandate to oversee banks��� soundness, and that it does not need mandate from the Congress for this. It may have the authority, but it is uncertain if it will be able to effectively restrain the salaries and bonuses of bank employees without the enthusiastic backing and support of the White House.

Banking is one of the most globalised industries. International cooperation would, therefore, be needed to regulate this sector. European countries that have proceeded with regulating executive salaries are hoping that the US government will follow similar policies. If it does not, the EU countries would come under considerable pressure from their banks to become lax on these restrictions.

(The author is associate professor, Columbia University)