January 13, 2010
An Education: Banker’s Compensation and Political Legitimacy
Posted by Erik Gerding

With respect to executive compensation, I’ve long found Jensen & Meckling to be fairly persuasive: “it’s not how much, but how.” I’ve also found executive compensation to be a lesser issuer in terms of crisis causes and crisis remedies. When listening to a Congressman on NPR about a month ago criticize the Treasury Department for not “getting it” and putting executive compensation on the back burner, I told my wife, “I don’t think he gets it.”

Now I’m beginning to think, we (or at least I) have not been getting it. What happened to me? Part of it is that I got an earful from Ma Gerding at the holiday dinner table. Part of it is realizing that this is not just an issue of efficiency, but an issue of political legitimacy. A broad swath of the public on all ends of the political spectrum (Ma Gerding is definitely not a member of the Tea Party) feel the game is rigged. Or to borrow a phrase – the bailout has been “socializing loss and privatizing gain.” I worry that if scholars of my political bent merely dismiss executive compensation as a populist issue, we are setting the stage for political conflagration.

But, how do we address compensation in a principled way that addresses legitimate concerns about systemic risk without creating policies that are either draconian or mere smokescreens.

I share Christine’s concerns about government forcing some firms to take bailout money and then looking to use that as leverage for regulation even after a firm has fully repaid the TARP money. Now, as I noted in an earlier post, firms like Goldman have fully repaid only the money directly loaned to them. They haven’t repaid the money they indirectly received as creditors of bailed out firms like AIG. But insisting that this implicit loan be repaid is problematic. It could justify asking the Goldmans of the world to pay anything or very little at all (“Lloyd, why don’t you just get the next round.” “Gladly, Hank. I forgot: how do you like your martini?”)

My disposition pushes me to focus on crisis prevention rather than hashing through crisis management. I’ve enjoyed reading Lisa’s posts  and the Cherry & Wong paper  on clawbacks. But, I wonder whether it would be simpler and less legally problematic, if, instead of building clawbacks into executive compensation, we considered regulation that pushed compensation to be more oriented towards long-term share value. That would address the same concerns about share price manipulation and investment that gin up short term profits at the expense of long-term risk.

How could this be accomplished via regulation? As one example, the FDIC is currently considering linking their deposit insurance premiums charged to banks to risk in their compensation schemes.  That strikes me as one of the most innovative ideas in the reform mix. In contrast to an earlier post on new “risk taxes” on banks, this seems like good outside the box thinking because it re-fashions regulatory tools with which we already have experience.

Maybe my education is getting me nowhere, and I am back to "not how much, but how."

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