Columbia professor Amar Bhide on executive pay and Tarp II

The Treasury Department´s new pay cap for banks using Tarp has gotten plenty of attention on the news, despite its fundamental lack of teeth. Even if it doesn´t work, big-name executives on camera have looked worried over the prospect of lower pay. But Columbia University business professor Amar Bhide isn´t impressed. Chatting with BankThink this today, Prof. Bhide says previous caps didn´t work, and this one appears no better. A real plan, he says, would actually address the perverse relationship between government and Wall Street, where executives can no longer expect the taxpayer to make up for their failings.

BankThink: How does the Treasury´s new executive pay rule compare to past efforts to limit bankers´ compensation?

Amar Bhide: None of these executive pay caps have worked in the past, and there´s no reason to believe that they´ll work in the future. They tend often to do more harm than good. ... We saw this in 1994, when they were going to heavily tax all compensation over $1 million that was not tied to performance. Then new schemes came out of the woodwork to [increase pay] ... In the case of banking this is particularly dangerous. In the financial industry, you can on average increase your earnings by taking more risk. And it´s impossible to define risk once and for all.

BT: Can you give us an example of where this backfired?

AB: The alums of Harvard got upset at how much the people running Harvard´s endowment were making. So the guy that used to manage money for Harvard left to set up shop on his own and Harvard gave him some of the money he used to manage the endowment in-house to manage it as a hedge fund. He didn´t change things that much, but at some point his positions went bad. If he had been working at Harvard he could have gone and asked for more capital until the true value of the position could be restored. It would only have been needed for these two or three days. But since he was not playing inside the house, the capital was not forthcoming, and he pretty much got wiped out. He lost 50% of the value of his assets.

BT: So how does this relate to the relationship between banks getting bailout money and the Treasury restricting pay?

AB: It´s all very well for Goldman Sachs today to say to the government, `We don´t need your money now.´ But there are times, and more often than Goldman or anyone else would care to admit, that it needs to be backstopped. And how much of Goldman´s returns come from the knowledge that it could be backstopped on these rare occasions? Like when the over-the-counter derivatives market falls apart, the Treasury or someone else steps in and makes it good. So to claim that Goldman is not really relying on the Treasury´s support, that it´s actually bearing its own risk, is nonsense. And then if the Treasury is going to be bearing risk then it makes sense for it to say `we should have some say in your compensation. At the very least we should limit your compensation to what you were on without us helping out.´ But as a practical matter that doesn´t work. You put on these pay restrictions and then Goldman, just as Harvard, will ... move some kinds of these businesses outside of Goldman. But this doesn´t mean the Treasury won´t be liable for these risks. We´ll remain liable for these risks and we´ll have no control over what these guys are getting paid, so the compensation rules are really worthless.

BT: So how can we actually hold risk-taking executives accountable while addressing the public outcry over the news of their lavish compensation?

AB: Name and shame is important. In many, many professions where the value of an individual´s contribution is impossible to manage and it´s certainly not determined in a classic auction market, one of the important restraints on compensation where there public finds the level of compensation obscene. There is social pressure. Markets have a winner-take-all element where, in some sense, the provider of the service can demand his or her price. The purchaser of the service really has no idea of what the next-best is. But historically professional norms have helped restrain this kind of compensation. Historically, people have said doctors should be well-paid, they should be members of upper-middle-class society, but they shouldn´t gouge. They should show some restraint in the fees that they charge. So social pressure in these soft markets does play an important role and I think for [President] Obama to say `You guys ought to behave and pay yourselves in a more responsible way taking into account where the rest of society is´ serves a valuable social and economic function. I think that is an important part of what´s going on. I´d rather see more of that and less of these peculiar rules.

Also, it´s high time that we constructed a financial system where we the taxpayers don´t subsidize the accumulation of extreme wealth. It´s one thing for investment bankers and traders to make a lot of money based on their own wits. It´s another if we construct a heads they win, tails they lose game.

BT: How do we fix that?

AB: Cut off the supply of subsidized debt to these guys. Make sure that their trading activities are well insulated and don´t draw on any sources from taxpayers. If you cut off the supply of bank credit to risky financial innovations, it´s not that these innovations would starve, the scale would be much smaller. If the scale were smaller they wouldn´t make as much money as they do.

Let some of these guys go down. We let all other kinds of businesses go bankrupt, we have a process of shutting things down in an orderly way and saying that letting Lehman Brothers failing was bad simply because what followed was unpleasant doesn´t make sense. If we suffer a period of temporary harm and temporary setbacks, so be it.

BT: But the overwhelming consensus is that Lehman´s failure had a huge impact on the stability of the global financial markets.

AB: We´ve heard this over and over again-oh if we don´t have Tarp, this will happen. Bad things have happened anyway. There is a value that is far deeper than how quickly the financial markets restore themselves or not to observing due process... The scandal is not that Lehman was allowed to go bust, it was that Lehman was allowed to lever itself up to 30 to 1 and that people were allowed to make a lot of money doing things that should never have been able to due in a truly free market.

BT: We´re at a crossroads now, with a new rescue plan about to be announced. What do you hope to see?

AB: We should have no new programs. We should have simply follow well-established processes for dealing with failing banks. The [Federal Deposit Insurance Corp.] has a program designed for this. If it needs more capital, give it more capital. If it needs more staff, give it more staff. But why invent something new that could be rife with cronyism. Why did we set up the FDIC? Just for these types of situations.

BT: Thanks