Should Obama regulate Wall Street pay?
May 13th 2009 11:00AM
Updated Dec 4th 2009 11:45AM
Yes, he can and yes, he should. There is no doubt in my mind that people go to Wall Street for the money. They learn the rules of the game and they play hard to get the most money in the shortest time. As Wall Street pay has grown -- the average Wall Street bonus climbed 19-fold from about $10,000 in 1985 to almost $190,000 in 2007 -- more and more of the most talented people in the world have flocked there, and away from other parts of the work world.
But the opportunity cost of taking talent from building more energy efficient vehicles or finding a cure for cancer and putting it in a hedge fund is not the biggest problem with Wall Street pay. It's that Wall Street's pay plan leads bankers to make the biggest bets in the shortest period of time so they can win the lion's share of the bonus pool. When those big deals went bad, Wall Street's bankers got to keep their money and stick the cost on taxpayers.
To avoid a repeat, President Obama is wisely thinking about changing the rules on Wall Street pay. He wants all financial institutions (FIs) -- including banks, hedge funds, and private equity firms -- to follow formal pay guidelines. While the details of these guidelines are not yet out, the most interesting part of them is that these guidelines would apply equally across Wall Street, whether a bank had taken TARP money or not. This is 100 percent guaranteed to yield shrieks of outrage from the hedge funds of Stamford to the trading floors on Broad Street.
What guidelines should Obama require FIs to follow? As I have posted over the last several years, I think Obama should require FIs to put bankers' pay in an escrow account. If after, say, three to five years, the deals that each banker originated have held up well, then the money in the escrow account can flow into the banker's hands. If those deals lose money, the escrow account goes to compensate the investors for their losses.
Why is this escrow account a better idea? Because Wall Street people will do what they need to do to get paid the most money. If their own compensation is tied to both the return and the risk of the deals that they bring in, then they will be much more careful to consider the risk side of the equation. And instead of getting $18.4 billion in bonuses in 2008 -- year when the FIs brought the global financial system to its knees -- bankers would have been watching those escrow accounts flowing to investors instead.
This will probably mean that Wall Street does fewer deals. And that would mean that Wall Street would pay less and attract fewer people. It would also mean that if bankers brought in bad deals, they would pay the price -- rather than being able to shift the losses onto taxpayers.
That sounds like a free market to me.
Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College. His eighth book is You Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing.