| |||||||||||||||||||||||||
| |||||||||||||||||||||||||
Although Wolf keys off a paper by Harvard Law School's Lucian Bebchuck and Holger Spamann on executive compensation, he's really taking a broader view of the phenomenon. Shareholders of such a TBTF bank have every reason to bet big on the ability of an institution to jack up risk and go for the big score. After all, the upside is nearly unlimited and the ultimate downside, failure, is cushioned by a government that can't let a TBTF institution totally crap out. For the shareholder, the worst that can happen is that his equity stake goes to zero, which is bad, but not nearly as ugly as in the days, now lost in time, when shareholders would be responsible for losses, like those poor Names at Lloyds. That bias toward the upside, Martin argues persuasively, was baked into everything from compensation structures to leverage ratios. There are really two solutions to this problem: break the magic spell of TBTF or reinstall full liability for shareholders. A few thoughts occur. First, this puts governance when it comes to the banks in a harsh new light. Wolf's argument confirms the sense that not only were shareholders failing to monitor the banks for risk; they were actually driving them on. Thus the governance "solution" here -- give shareholders more power on "say on pay" or on director elections -- would only make a bad situation worse. If Wolf is right, then the issue of pay needs to be separated from that of shareholder rights, leading to tougher rules on compensation, particularly in the use of equity or equity options. Second, it brings back the question of limited liability in banking. Wolf doesn't explore this in great depth because it's never going to happen. But the re-imposition of full liability would awaken shareholders to their full responsibility as monitoring owners. It would also send them racing to the exits, producing a much smaller banking sector as popular as a class of swine flu victims. All this reveals just how privileged shareholders are, at least in banking. They can come and go freely; they get unlimited upside and limited downsides; and they get various government safety nets. Wolf also traces a similar decline in creditor interest in bank assets or risk-taking that stems from the backup role of the government. "[Creditors] appear to have lent to the banks. In reality, they have lent to the state." Wolf's exploration through bank shareholder-dom takes us to the ultimate political realpolitik of regulatory reform: Washington doesn't want to reel in the banks because it believes it will come at too great an economic price to the public. Limited liability is an extreme case, but useful nonetheless. To reinstate full liability would be to fundamentally transform incentive structures in banking. It would be infinitely safer, and deal with the TBTF problem as well. But who would provide equity capital? The upside would be very limited as risk is dialed back and the downside would yawn open like the gates of hell. Banks would become radically risk averse. Only the best borrowers, backed by unimpeachable collateral, could borrow. Mortgages? Forget it. Credit cards? Not a lot. We'd be back into a credit-starved, liquidity-parched, tight-money world. Now, of course, that's not going to happen. The administration is not going to throw money at the banks to get us out of this mess, only to put us back in by choking off credit again. Still, there are other ways to force better accountability onto shareholders, managers and directors that might not be so draconian. One of them, of course, is to make banks smaller, less interconnected with more capital and less leverage. The simple removal of the implied TBTF guarantee -- that is, the re-imposition of moral hazard -- would place more risk on shareholders, who would force institutions to compensate by reducing risk. But that too would shrink the credit and liquidity in the system, leaving us with higher unemployment, lower growth and a clutch of chronic problems. It is a chastening thought to consider that the political class may well believe that the system can run most optimally only with an implied government guarantee of the largest banks. An aside: It remains remarkable that all these arguments fly back and forth about what to do with the banks -- nationalize them, break them up, bail them out -- without any sense, even a shot-in-the-dark forecast, of what the effect on the real economy these various scenarios would have. What is the relationship between these factors? The fact that we can't seem to do that suggests the limits of economics. Or it may mean that no one pushing a policy wants to look down that dark hole. Wolf's argument drops us off where we were when these reform plans were released: Politically, no one seems willing to reduce the scale of banking because of the fears, or uncertainties, of the economic fallout. It hasn't quite sunk in yet, but Wolf points out that the shareholder-centric model has achieved that favorite designation of the moment -- it's a zombie. The administration's answer is to replace monitoring shareholders with an empowered Federal Reserve. Well, at least the incentives will be different. Or will they? - Robert Teitelman See story from The Big Picture Robert Teitelman is the editor in chief of The Deal.
 Deal Video
    Community
 Elsewhere on The Deal.comDealwatch
The Deal MagazineCorporate Dealmaker
The Deal VideoCategories
Blog roll
Archives
| |||||||||||||||||||||||||
Criticism continues to rain down on the president's regulatory reform proposals, from Barry Ritholtz at 
|
|
|
|
|
I addressed this issue sometime ago, noting:
“We’ve come a long way from the days when the man atop the organizational chart made 40 times what the person on the lowest rung earned. Over the past few decades, executive compensation has exploded, with some CEOs taking 200, 300, even 400 times the base pay at the company.
With so much of this compensation made via options-based incentives, the bosses had every reason to swing for the fences. The upside was all theirs, and the downside was the shareholders’—and taxpayers’.
But don’t for a moment think their terrible track record had a negative impact on their compensation. Despite their performance, these CEOs were paid as if they were enormous successes. The compensation figures that follow are enormous; that they were paid for such abject failure is a national embarrassment.
It is also an indictment of three major corporate governance issues that have not been discussed widely enough. The first is the crony capitalism that was rife in boardrooms across the United States. The cronyismof major corporate boards, especially those in the finance area, has become legendary. Rubber-stamp directors who rarely buck the chairman or challenge the CEO are unfortunately all too common. These boards did not serve either their companies or their shareholders well.
Also enabling this festival of greed are the large institutions that held the companies’ stock, most especially the big mutual funds that have been AWOL when it comes to policing the senior management. They have the time, expertise, and incentives to do so; it is beyond the capability of individual shareholders. Besides, it makes no economic sense for someone who owns 100 or 1,000 shares of stock to act as overseer and scold to corporate boards. But it was squarely in the interest of owners of 10 million shares and up to do so. Why the mutual fund complexes failed to protect their shareholders is hard to fathom. Perhaps when it comes to the finance sector, they feared missing out on syndicate deals and hot IPOs if they asked too many questions.
Then there are the so-called compensation consultants. They did a horrific disservice to the shareholders as well as the companies. The role of these primarily ethic-less weasels was to give cover for these ridiculous compensation packages. I would love to see a review of the packages as written back then. If the compensation experts were members of an actual profession with standards and ethics, they would be drummed out of that profession. Instead, these people were merely tools used by the C-level execs to transfer vast sums of wealth from the shareholders to themselves.