Story Highlights:
• The Fed is aiming to regulate Wall Street pay structures
• Focus is on firms still receiving bailout money
• This measure could have longer-term consequences
Everyone is pointing to pay structures on Wall Street as a key contributor to the financial crisis. The pay packages of these firms are being criticized for incentivizing excessive risk-taking through salaries and bonuses directly tied to individual revenue brought in. Furthermore, taxpayers are frustrated that Wall Street executives are still walking away with golden parachutes while they bear the burden of the bailout and recovery packages. The Fed has focused its attention to reforming compensation on Wall Street.
On October 22, Treasury official Kenneth Feinberg announced a forced end-of-year compensation reduction for the top 25 executives at the seven companies that have received a majority of the bailout money. The targeted seven include American International Group Inc., Bank of America Corp., Citigroup Inc., General Motors Co., GMAC Inc., Chrysler Group LLC and Chrysler Financial. The executives’ overall compensation will be capped at $500,000, which forms a 50 percent cut in the group’s overall pay level from the previous year. This rule will continue to be enforced until the companies repay the money from government aid.
Feinberg continues to emphasize his ability to enforce pay clawbacks over firms still receiving bailout money. He also suggested that all banks that have received TARP money would be under scrutiny for implementing clawbacks and other pay structure regulations. This is pressuring banks to detach themselves from government bailout money.
The Fed is still in the decision process regarding long-term pay structure regulations. They have announced that their main concern is with the top twenty-eight banking organizations. The Fed has also stated that they will not enforce a long-term definitive pay cap, but rather require compensation be based more on risk-adjusted P&L. For example, this suggests that when comparing two traders who generated the same revenue for their firm, the one who took less risk in doing so could be paid more. To additionally reduce risk-taking incentives, we will likely see banks paying out more in the form of stocks, options, and other forms of equity-tied compensation to promote long-term outlooks.
Feinberg’s rulings could put two of the major banks – Citigroup and BofA – at a major short-term disadvantage against competitors not yet under pay rules. If the Fed does not enforce pay cuts elsewhere, Citi and BofA executives will most likely move to competing firms. Overall, if enforced pay cuts continue to be selective, we can expect to see a huge number of executives jumping ship to competing firms that can offer more attractive salaries. This is putting major pressure on the Fed to establish reasonable long-term pay reforms in a timely manner.
Could this be the start of a new paradigm where banks lose their cache and top talent moves directly to hedge funds and private equity, which are out of the reach of these pay reforms? While reforming pay structures is necessary to de-incentivize risk taking, it does not fully ensure that a crisis will not repeat itself in some other fashion. With the possibility of more executives moving to hedge funds and PE firms, this competition has the potential to create another Long-Term Capital Management situation down the road. The Fed’s compensation regulations may have unforeseen longer-term consequences for the financial industry as a whole.
