Is the Treasury plan mostly politics? A powerful incentive to pay back TARP funds and avoid the risk of future bailouts? Will it be possible to attract competent management at those companies? Can the Fed be trusted to curb compensation when it never recognized that as a problem before?

Wage and price controls are not a new idea.  They are a very old idea with a consistent history of creating more problems than they solve.  There has always been a stain of thinking among those men and women who consider themselves wiser than the market to believe that they know the value of a product or service.  The only real value is what men and women freely choose to pay in a free market.  Everything else is a power play by special interests and the government bureaucrats that serve them.

The men and women who lost billions of other people’s money and who failed to oppose government policies such as Fannie Mae and Freddie Mac’s existence and the Community Reinvestment Act should be “punished” by losing their jobs and assets when “their” companies went bankrupt.  The government interfered with allowing the market to sort out who is responsible for what.  Trying to guess what salaries should be—paid with other people’s money—is hubris.  Stupid hubris.  Done before and always messed things up hubris.

The White House action to limit the amount of pay at the seven firms receiving government assistance, and to reverse pay decisions made only a few weeks ago, is transparently political, and that is the only thing transparent about it. The political objectives are to increase the President's popularity (everyone hates Wall Street these days) and to send Wall Street a message: "stop opposing 'change'". This policy will hobble the ability of these seven firms to attract good management at a time with management is essential to their turnarounds. That is bad for the firms, their stockholders (that includes us taxpayers), and our democracy, which is now asked to accept micromanagement by the White House regarding which employees at these firms get high pay and which don't, which perks are legitimate and which are not, etc. These decisions are based on the pronouncements of a "pay czar" who is subject to no external review and who acknowledges that his objective was, in large part, to create a solution that would be politically acceptable.

The Fed's announced action is different. Compensation is an integral part of risk management at banks because it determines the incentives of decision makers toward risk. It makes sense, therefore, for the structure of compensation (not its amount) to be regulated as part of risk management. The question is whether the Fed will be able to do this successfully. I am keeping an open mind and look forward to seeing the details of how compensation will be regulated. By requiring delayed vesting and/or clawbacks of bonuses based on long-term outcomes, in theory it is possible to encourage managers to maximize long-term firm value, not just short-term profits. So, if the Fed avoids counterproductive limits on pay amounts, and focuses on pay structure, that could be helpful. (The lack of Fed independence at the moment, of course, raises legitimate concerns about whether the Fed's new pay regulation will be implemented in a sensible way.) Another potential problem is that bankers are smarter than their regulators and will find ways to game any regulatory system. But the fact that compensation regulation will not work perfectly does not mean that it will not improve risk management and value maximization incentives. In my view, regulating the structure of compensation to ensure incentive compatibility of compensation is worth a try.

“The government just announced two sets of actions to constrain the compensation that banks pay to their top executives. First, Kenneth Feinberg, the administration’s “special master” for compensation at the handful of companies that were most thoroughly bailed out by taxpayers, just announced the agreed compensation levels for the top 25 executives at each of those firms. Compensation levels were halved compared to the banks’ requests and a very high percentage was redirected into company stock instead of cash. Second, the Federal Reserve (Fed) announced draft guidelines to avoid compensation practices that might encourage banks to take excessive risks. Here are my brief thoughts on both: Continued Below

1. Feinberg's executive pay plan. Since taxpayers have such a big stake in the success of these companies, I think the main test should be whether the actions are those that a smart private owner would have taken. I think they are not, since they send the wrong message to the people working there or considering working there, which is that their pay will not be determined the same way as on the rest of Wall Street and will be considerably lower and more volatile. This risks losing the best people, since the ones that move are always those who have the best options elsewhere. That said, the plan could have been considerably harsher, so this may be the best we could hope for, given the politics.

       2. The Fed's plan is a good one, but I wouldn't expect big changes as a result. They are focused on situations in which the compensation plan fosters excessive risk, which is very different from the populist concern about how overpaid bankers are. There is no attempt to limit total compensation levels, nor do I think the Fed should try.”

“The Treasury executive compensation proposal focuses on compensation for top executives at 7 institutions that have accepted exceptional assistance from the federal government. For any institution that accepts taxpayer dollars, reasonable restrictions are part of the territory. It should be noted that Congress has imposed restrictions on TARP companies by limiting tax deductions and prohibiting any incentive compensation.

The Treasury proposal correctly focus on reducing excessive risk-taking and eliminating those compensation programs that focus on the short-term, rather on the long-term risk horizon. This focus on excessive risk eliminates incentives for executives to maximize quarter-over-quarter profits. This is the correct focus because it benefits the bank, the sales force, and the customer.

While the Treasury has the correct focus, it relies on reducing or banning pay and setting specific dollar limits on all types of pay to achieve its objective. While there are arguments on both sides about whether this is appropriate for the 7 institutions, this approach should not be applied to the broader industry.

The danger created by setting specific pay restrictions is they will be both over-inclusive and under-inclusive at the same time. Each institution and employee is unique and compensation packages need the flexibility to recognize this. Additionally, specific pay restrictions will cause a “brain drain” of executives who will leave the company for compensation based on market forces. Specific restrictions will thus reduce the ability of the company to attract and retain qualified employees, who are needed to help strengthen financial institutions.

The Fed guidance focuses on the entire industry under the Fed’s jurisdiction and potentially applies to all employees working at those institutions. It divides the industry and gives extra levels of scrutiny to the largest 28 banking organizations. The financial services industry did a poor job of managing some of its risks, including ‘compensation risk’, and this contributed to the failure of many institutions.

The guidance from the Federal Reserve shares the same goals as the Treasury proposal of reducing risk, however it achieves those goals with a different carrot. The remedy the Fed proposes is the more effective one. It does not focus on setting specific dollar pay caps, but rather, it is search and destroy mission to attack the root of the problem: excessive risk. The proposal seeks to eliminate any compensation practice that encourages any employee- from CEO to loan officer to trader- from engaging in behavior that exposes customers or the institution to excessive risk. The Fed proposal threads the needles of protecting institutions and consumers and attracting and retaining talented employees.

It is important to note that the financial services industry has already moved to eliminate incentives to take excessive risk and to better align compensation practices with the long-term risk horizon. The industry is using claw backs, salary deferrals, stock options, and long vesting schedules for stock options. These devices will align the interests of all employees with the long-term risk horizon of the company and the customer.

Both the Treasury and the Fed proposal focus on long-term risk, they just achieve their goals in different manners. The Fed method will help individual institutions, the industry, the economy, and the consumer better realize the benefits of financial transactions.”