By Martin Hutchinson
Contributing Editor
Money Morning
By revamping the banking sector's compensation system, and creating a salary cap of $500,000 for the top executives at institutions that accepted federal bailout money, new U.S. President Barack Obama could be launching a reform movement that helps make the American financial system worthwhile to invest in again.
For the last 30 years, Wall Street has had a problem with its remuneration system. Base pay was only around $150,000 even for a partner/managing director – not enough to live on for senior Wall Street bankers with a Manhattan lifestyle – while bonuses were 10, 20 or even 100 times that amount.
This promoted a culture in which risk-seeking behavior was encouraged – even rewarded – which is why the notorious office politics and 1egendary 100-hour workweeks became the Wall Street norm. Needless to say, shareholders in such institutions got a pretty raw deal; the universal assumption was that their returns would be whatever crumbs were left over after management had paid itself gargantuan bonuses.
It becomes easy to see, then, just why President Obama's limitation will have an interesting effect. Some financial-services businesses – consumer lending, mortgage banking, routine business banking (including much large ticket lending) and retail brokerage – work very well at the operating level with a $500,000 salary cap. There are plenty of practitioners available with lots of experience in these businesses, whose remuneration, except at the very top, never soared to "Wall Street" levels.
Meanwhile, other businesses will become more or less impossible, except at a routine level. For example, if you try to engage in big-ticket trading, while paying traders $200,000 to $300,000 a year, and your competitors pay traders $2 million to $3 million a year, you will get your lunch handed to you on a fairly regular basis. The top Wall Street traders mostly got that way by developing an intimate knowledge of some major portion of the market's deal flow, and that knowledge is worth millions to somebody, even if a particular bank's salary structure is capped. Similarly, the top block traders in equities, the top merger specialists, and others, will not stick around for less than $500,000 a year.
After a year or so, a bank subject to a salary cap will be a very different creature. At the top, it will have primarily administrators, paid substantially more than their government counterparts, who will run a perfectly competent operation, but who will not be capable of broad strategic insight or aggressiveness, be it offensive (acquisitions) or defensive (major cost cutting).
The organization will compete only in those financial-service businesses that have become routinized. However, such businesses represent perhaps 90% of all financial-service transactions, so being limited in this way will not put the firm at a huge disadvantage. More importantly, each company's risk management function will become very simple, since nobody will benefit significantly by taking on much more than modest risks.
Had regulators prevented the mortgage finance institutions Fannie Mae (FNM) and Freddie Mac (FRE) from paying their top managements $10 million a year, they would have been successful and low-risk models of this type (and we would all be much better off today).
With simpler risk management than their unrestricted competition, and much cheaper management at the top, these new banks will be highly competitive in the businesses in which they operate. Given such parameters, it is likely that their unrestricted competitors will either have to reshape themselves to match them, or get out of the commoditized businesses and concentrate only on high value added, high-risk markets.
This would be completely appropriate.
If the largest banks are to be considered "too big to fail" and must be bailed out from time to time with taxpayer money, then they must be prevented from taking large risks. By restricting their management's remuneration, Obama will also have restricted the taxpayer's downside risk, while at the same time providing more cost-efficient services in these commoditized business areas.
The high-risk and complex businesses will migrate to other houses, whether hedge funds or investment-banking "boutiques" – the former specializing in operations requiring large amounts of risk capital, and the latter specializing in operations requiring high-level financial creativity and connections.
If the authorities are wise, they will impose a size limitation on these operations, so that they are unable to become large enough to endanger the financial system or require taxpayer bailout. Naturally, pay for executives in these companies will be unlimited, in good years far higher than in the commoditized behemoths.
In general, the ordinary investor would be foolish to invest in the new hedge funds and investment banking boutiques. Insiders at those operations will always have an advantage over their outside investors, and will tend to treat their capital sources as "dumb money," suitable only for extracting large management fees. The largest institutions, with an ongoing relationship with these houses, will be their primary sources of outside capital, but many of them will rely heavily on reinvestment of partner earnings, as Wall Street houses did before 1970.
For retail investors, the huge salary-capped behemoths will be ideal "widows-and-orphans" investments. They will not grow much, so will pay out most of their earnings as dividends. They will also not take large risks, so their earnings will fluctuate only moderately in any but the deepest recession. Because of their attractiveness as investments, they will have a very low cost of capital, another cost advantage enabling them to repel encroachments by more aggressive houses.
In general, as a believer in the free market, I strongly deprecate limitations on executive pay. But when the institution concerned is "too big to fail" the argument for such limitations is very strong indeed.
[Editor's Note: In the midst of a financial crisis that's eradicated more than $6 trillion in shareholder wealth, the profit search facing U.S. investors is even tougher than ever. Money Morning is offering a new report that details the additional dangers posed by the ongoing bailout payouts and the stimulus outlays that are to follow. The report is free of charge, and details ways that readers can obtain a complimentary copy of The New York Times best seller, "Crash Proof," in which author Peter D. Schiffpredicted the housing bubble and the crash of financial-asset prices long before they happened, and outlines ways investors can avoid further losses and even post profits. To read our free report, and to find out more about this offer, please click here.]
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Obama's Pay Restrictions Send Tough Message to Wall Street
Its time we socialize things and get back to basics.
Time enforce all anti American laws and have some public executions! Stone em and get our business some integrity! Start with politicians, lawyers and doctors!
The premise of limiting executive pay to fix the behavior of Wall Street is rather shallow thinking. Focusing banking management into "competent administrators" who are happy with limited pay is a recipe to move the industry into a pseudo-government philosophy that takes no risk and will eventually whither. This is a really dumb idea and supreficial on how to correct the economic problems we face today. it does make good press, but I thought your purpose was to provide unbiased analysis.
Excellent analysis. The "whiz kids" have their place in our economy and we need them. We just don't need them to play with ALL the cards.
Interesting article but knowing how people can game a system I doubt that this will eventually have any better result then we have now. Funny, how no one is bringing up the point that much of this disaster was caused by the law change eliminating Glass-Steagall. Glass-Steagall was put in to effect in 1933 and served us well. When Clinton signed its death the risk takers were then able to get together with the conservative bankers and screw the system. 6 Trillion in the dumper later still no one mentions one of the major causes. Amazing
"Had regulators prevented the mortgage finance institutions Fannie Mae (FNM) and Freddie Mac (FRE) from paying their top managements $10 million a year "
I think we'd be reading an entirely different article today, if that had happened. That's the type of changes government should be focused on; fix the parts of the system they are already responsible for.
I do not believe that paying CEOs excessively makes them any better CEOs. In fact they get corrupted as the meltdown has proved.
Taxes tend to encourage people to seek devices to avoid and/or evade what they consider as Government taking away their lawfully earned returns. Instead, it would be better to eliminate personal income taxation and replace with better scrutiny of corporate taxes, trading taxes and not allow any form of deductions at all. Government, as it is doing presently doing, should print its requirements which would be more easily monitored by Congress and Senate, and would be a tax on the whole population through managed "inflation".
No one ever works ahrder than the person who owns the business,
Yes cap the salary and make the bonus the reward,
open to all in the company,
This makes all working as an owner of the business, so all employees will work harder to gain more bonus money,
also capp the expenses tighed to performance bonus,
We had the case where a company CEO lost 28 million for a large Telco in Australia recd a bonus, as they sold assets so the loss against the capital assset sales a false, profit, allowed the no good CEO to make a bonus, how silly of the system.
Repealing Glass- Steagle was indeed a factor, but the key that opened Pandoras Box was the SEC ruling on April 28th, 2004 that allowed unlimited leverage by the big five investment banks. Check it out on Wikipedia under the name William Donaldson!!
Noone is even mentioning the actual cause of all this mess. Banksters counterfeiting money and 'loaning' out that counterfeit money is robbing the entire US economy, of TRILLIONS on a regular basis. It created the Great Depression, and it has caused all Americans to go into debt for life to buy a place to exist. These banksters heavily contribute to PACs on both sides in elections, so that whoever wins, is still indebted as an accomplice. Quid pro quo. I don't think even Ron Paul has mentioned this small fact concerning 'Mariginal Banking', or digital counterfeiting.