Retribution or reform?

Kenneth Feinberg, the so-called US "pay tsar", is being congratulated for ordering the financial institutions still receiving US taxpayer assistance to slash their executive compensation by an average of 50 per cent. While understandable, the move may well be counterproductive.

Feinberg, appointed the special master of compensation by the Obama administration in June, oversees compensation within the seven institutions still in receipt of bailout funds – Citigroup, Bank of America, AIG, Chrysler Group, Chrysler Financial, General Motors and GMAC – and has ordered the companies to reduce the cash compensation of their top 25 executives by up to 90 per cent. He has previously pressured retiring Bank of America chief executive, Kenneth Lewis, to forgo his 2009 salary and bonuses entirely.

While clamping down on the compensation to the groups still supported by US taxpayers plays well in terms of its politics, unless it is part of a broader package of remuneration reforms that affects all US companies – or, more particularly, US financial institutions – it looks more like retribution than reform.

The effect on the companies concerned will be to drive their best executives into the arms of companies that aren't subject to the restrictions on compensation.

They don't have to look far. Whether it's Goldman Sachs, JP Morgan Chase, or Morgan Stanley, the old Wall Street investment banks are back in the game, using their ability to borrow near-costless funds from the Federal Reserve to resume large-scale, and very profitable, proprietary trading and return to the big bonus gravy train that was so rudely interrupted by the global crisis they played such a major role instigating.

Citi, which hasn't dialled up the levels of its trading activities, has been struggling to generate earnings growth and offset the general deterioration in the quality of its traditional loan book. It will be very hard for it to compete for staff, or simply retain staff, in competition with those banks that are churning out trading profits and bonuses.

It was notable, overnight, that Morgan Stanley – which had been lagging in the resurgence stakes compared to its former Wall Street peers, because it hadn't been prepared to accept as much risk – lifted the value-at-risk in its balance sheet to its highest level in nearly two years, after conceding in July that it hadn't taken as much risk as it could have.

With all the banks now re-hiring after shedding staff during the crisis, compensation is now a competitive advantage, or disadvantage. Morgan Stanley has put aside $US10.9 billion for compensation and benefits so far this year – 64 per cent of the revenue it has generated.

If remuneration reform is supposed to deal with one of the flaws in the financial system revealed by the crisis – the relationship between incentives and risk-taking – punishing the risk-averse and allowing compensation-driven competition for talent is hardly progress.

In our market, the proposed Australian Prudential Regulation Authority reforms to the remuneration practices of the institutions it supervises are being undermined, even before they are in place, by the federal government's changes to the taxation arrangement for employee share schemes, where the incentives will be taxed on termination of employment.

APRA, like most of the global agencies, wants departing executives to have incentives locked up and at risk well beyond their time of departure from the institution, to encourage longer term decision-making and discourage short term risk-taking.

The developments in the US, the imminent changes in this market and the unintended consequences they could produce ought to add urgency to the introduction of sector, or economy-wide reforms to compensation, particularly within the banking sector. At present the proposals are mostly caught up in talk and politics.

The philosophy shouldn't be to crudely attack incentives/bonuses, but rather to ensure that the structures of incentives that could encourage excessively risky behaviour are modified and supported by changes to the capital adequacy regime for regulated institutions, so that there is less risk of recent history repeating itself.