Will Obama Capping Executive Pay Create a Better Banking System?

By: Money_Morning

Martin Hutchinson writes: 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.

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