Friday, July 9, 2010

Risk and Reward - executives, shareholders, society

"Two years on from the global financial crisis, these tough new rules on bonuses will transform the bonus culture and end incentives for excessive risk-taking. A high-risk and short-term bonus culture wrought havoc with the global economy and taxpayers paid the price. Since banks have failed to reform we are now doing the job for them", said British MEP Arlene McCarthy (S&D).

The European Parliament passed new rules Wednesday capping cash bonuses and requiring 40 to 60% of any bonus to be deferred for at least 3 years. For those of us who saw as a silver lining in the sub prime mortgage debacle the ability to address problems in the financial services industry, this is a welcome effort.

The EU’s bank capital rules will now cover executive compensation. In addition there will be stricter capital rules on bank trading activities. According to the EU ‘Studies show that the rules are expected to lead to banks having to hold three to four times more capital against their trading risk than they do at present.’ The proposed senate legislation implementing the Volker rule addresses similar issues, limiting proprietary trading and investment activities at US banks.

Ideally, this is just the beginning. It is not only the interests of shareholders that should be protected, but the interests of all stakeholders. In an analysis of alignment of interest between executives and shareholders, Thomas F.Cooley writing in Forbes concludes ‘But it is also important to understand what (the charts) don't tell us. They say nothing about the appropriateness of the levels of compensation in any of the sectors, or disparities between the largest players and smaller companies. Further, these charts don't say anything about the alignment of managers' and shareholders' interests with those of society or taxpayers.

The latter is a particularly troublesome issue when we are talking about banking and finance. At the heart of the anger about bankers pay is the very legitimate concern that the bankers and their shareholders and debt holders benefit from a subsidy paid for by taxpayers--the subsidy that is implied by the notion that they are too big to fail. That subsidy empowers them to take bigger risks and earn bigger returns for themselves and their shareholders with all of the down side risk born by Main Street. That is the real outrage.’

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