Wall Street Reform May Not Go Far Enough

The financial reform bill  has passed both houses of Congress and is whizzing its way to the White House for the President’s signature as fast as it can get there.  Though its changes are many, in at least one area, executive compensation, they’re not quite as radical as some had hoped.

The bill does provide shareholders of public corporations a non-binding vote on executive compensation and golden parachutes. (A helpful synopsis of all the bill’s provisions is here.)

The bill does not take up a suggestion made by a group of 15 professors organized by Kenneth French of Dartmouth, called the Squam Lake Group. This group has been studying the financial collapse for the past two years and one of the ideas they support is bonus banking for executives. This is something some European banks embraced over a year ago. Basically a portion of executive pay would be held back for several years, so that the corporate titans who earned it would have to live with the results of their own actions a bit longer.  The thesis is that executives were taking too much risk because so much of their compensation was based on stock options, and the stock’s chance of big gains go up when more risk is taken.

The professors noticed that the big boon in stock option pay for executives was seeded in part by earlier government regulations that tried to cap pay levels. Those limited how much someone can earn in salary in one year. So the executive compensation committees began to replace salary with option-rich bonuses. By holding back some of their bonus, the academics reasoned, boards would be pushing leaders to think long-term. After all, they’d be eating their own cooking for years to come. In theory at least, they’d be throwing in their lot with investors, and investors might in turn be more interested in putting money in a firm under those circumstances.

Here’s how group member Robert J. Shiller described it in a piece that ran last month in the New York Times, well before the final votes:

IF our holdback measure had been in place before the last crisis, executives might have had serious second thoughts about giving a green light to mortgage-backed securities that would later go bust.

Both the House and Senate bills contain a requirement that mortgage securitizers share in the risk — by retaining an interest in any mortgage-backed securities they create, and not selling them all off to investors. That improves incentives, which is a good idea, but it has a narrow application.

The next crisis will take an unexpected form. Crises generally do. We need regulations that are based squarely on economic theory — sturdy incentives that really accomplish their broad mission.

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