There ought to be a law

Have you ever watched a major league infielder boot a routine ground ball and thought: “For the amount of money he’s being paid, he shouldn’t make that kind of rookie mistake”?  As a fan, it is frustrating.

That is how we should all feel about the crises that have rocked the financial world during the past few years.  A bunch of highly paid suits took way too much risk and made the rest of us poorer.   They walked away with pay and bonuses in the millions.

There ought to be a law against it.

There soon will be.  Thanks to European lawmakers, rules will soon limit bankers’ bonuses to no more than their base pay (twice their base pay, if bank shareholders agree).  The law will apply to European banks and their subsidiaries operating in the United States as well as to American bankers working in Europe, including the financial hub of London.

In other words, a banker making a base salary of $1 million per year will “only” be able to collect an additional $1 million in bonuses.  It is not uncommon for bankers to pull down bonuses equal five, ten, or even greater multiples of their base salary, so the law will have a dramatic effect on how bankers are paid.

Reining in bankers’ pay will no doubt be politically popular, particularly among those of us who take home salaries that don’t hit seven or and eight figures.

Ultimately, however, the new law will be both ineffective and self-defeating.

The law’s intent—to rein in bankers’ pay–will be easy to evade.  If a bank wants to pay its CEO $10 million, it can set a base salary of $5 million.  If the bank fails miserably, the banker will still walk away with a cool $5 million.  Hence, it is conceivable that the law will lead to an increase in bank CEO pay—including the pay of ineffective CEOs—which is probably not what European lawmakers intended.   This is already happening.

Contrast that outcome with the consequences of retaining the current system, in which a poorly performing CEO with a base pay of $1 million will earn at most $1 million.  Sure, $1 million seems like a lot to pay a failed banker—but it is a lot less than $5 million.

History provides a better mechanism for holding bankers financially accountable and discouraging the sort of high-risk behavior that got us into this mess in the first place.

During the 19th century, bank shareholders and managers–who were required to be substantial shareholders–were often subject to double liability, meaning that if they invested $100 in a bank, and the bank failed, creditors could sue them for $200.  Further, the shareholder was often subject to double liability for as long as three years after they had sold their stock in the firm, making managers think beyond their next paycheck and reducing their appetite for risk.

One way for modern corporate boards to replicate this result would be for them to make some portion of a CEO’s annual salary depend on the bank’s future performance.  This could be accomplished by including warrants or stock options that could only be exercised if the share price remained above some target value three years after the CEOs’ departure.

Such a system will be more likely to rein in CEO pay, particularly of ineffective CEOs.  More importantly, it will give CEOs an incentive to focus on the long-term health of their institution and hold them accountable for the consequences—both good and bad—of their leadership.

This would be a lot more effective than legislating limits on pay.

And it will make all of us feel better knowing that bankers, like professional baseball players, will be paid on the basis of performance.