The Financial Crisis Inquiry Commission said last month that Wall Street pay practices encourage traders and managers to disregard risk. Now federal regulators have proposed new rules on bank pay aimed at preventing another collapse. Yet those rules seem unlikely to curb aggressive risk-taking at Wall Street firms, which largely would have been in compliance with proposed guidelines on deferred compensation before the financial crisis.
The rules, drafted by regulators at seven agencies and approved for public comment by the Federal Deposit Insurance Corp. on Feb. 7, would require firms to spread at least half of top managers' incentive pay, including stock and options, over three years. The idea is to avoid rewarding executives for making short-term bets that pay off at first, then go bad.
Many of the financial companies that ran into trouble, though, including Lehman Brothers and Merrill Lynch, were deferring more than that before the crisis, according to an analysis by Bloomberg. "The FDIC is being pretty lenient with this formula," says Paul M. Sorbera, president of Alliance Consulting, a Wall Street executive search firm.
Lehman Brothers, which filed the largest bankruptcy in U.S. history in September 2008, paid more than 65 percent of each of its top executives' bonuses in restricted stock in 2007, including 89 percent for then-Chief Executive Officer Richard Fuld. None of the shares could be sold before five years.
Merrill Lynch, which agreed to be bought by Bank of America (BAC) in 2008 to avoid collapse, awarded its top executives more than half their compensation from 2004 to 2006 in restricted shares that vested over four years. Former CEO Stanley O'Neal received his entire $31.3 million bonus in 2004 in such restricted shares.
At the same time, some of the banks that emerged from the financial crisis in the strongest position wouldn't have met the new deferral rules before 2007. Goldman Sachs (GS) paid its top executives more than 50 percent of their 2006 bonuses in cash, according to company filings. CEO Lloyd Blankfein got $27.2 million of his $53.4 million bonus in cash that year. Goldman increased the deferred portion of executives' incentive compensation to more than 60 percent in 2007. JPMorgan Chase (JPM), which posted a profit every quarter of the financial crisis, paid its then co-heads of investment banking, Steven Black and Bill Winters, less than 50 percent in deferred pay in 2004 and 2005, according to company filings.
To be effective, new rules would have to require longer holding periods for shares and higher levels of stock ownership for top traders and managers, compensation experts say. Sanjai Bhagat, a finance professor at the Leeds School of Business at the University of Colorado in Boulder, Colo., proposes capping executive cash compensation at $2 million and making managers hold almost all of their stock until at least two years after retirement. "If they had done well while their shareholders did well, I'd be saying, 'Three cheers,'" he says. "But they did very well, while their shareholders did badly."
Warren Buffett, the 80-year-old billionaire chairman of Berkshire Hathaway (BRK.A), told the Financial Crisis Inquiry Commission in a May 26, 2010, interview that "You need a person at the top who has all the downside that somebody has that loses their job working at an auto factory." Buffett, who has about $49 billion of his net worth in Berkshire Hathaway shares, also said any CEO who has to tap the government for emergency assistance should "come away with nothing."
Rose Marie Orens, a senior partner at Compensation Advisory Partners in New York, says some aspects of the FDIC's proposal could have an impact. The rules call for banks to reduce the amounts paid based on losses that may appear during the deferral period. That creates more potential downside for executives than just a decline in the stock price would, she says. Even so, corporate culture has more influence over employees' practices than compensation rules. "What will change the behavior," she says, is companies communicating the idea that "knocking the ball out of the ballpark and then losing it all the next year" is not acceptable. That "isn't going to come from the comp alone," she says. "It never does."
The bottom line: Experts say proposed pay rules aren't likely to discourage recklessness on Wall Street because holding periods are too short.