Executive Pay in Banking Is A Symptom

The Fed and other politicians are now grabbing headlines by vetoing pay packages for banking executives. Look, there is no doubt at all that pay packages for public company CEO's in US public companies was, and is, out of hand. However, it wasn't the level of the payouts that got us into the financial meltdown.

The financial system, and especially the shadow financial system, originated and distributed products such as MBS, CDO's, and CLO's that shifted risks off the balance sheets of the originators and offered investors high returns with what they thought were AAA credits. The creation of credit default swaps, where a buyer or seller need not have any actual interest in the underlying interest caused this market to explode. Proprietary trading in these same toxic instruments was and will always be a very profitable business, because it is dominated by a few large traders and it is not transparent.

Regulation needs to address (1) bringing the shadow system into the regulatory light; (2) forcing originators to retain a substantial portion of the securitization on balance sheet; (3) reforming the rating agencies that gave the AAA tranches their unjustified ratings; (4) perhaps requiring that traders in credit default swaps have some demonstrable interest in the underlying instrument; (5) meaningful SEC regulatory review of financial product creation process-- a firm can't just decide to package pay day loans into a new class of securities without going through some meaningful examination.

Corporate boards of large financial services company were ill equipped to deal with these issues. Jay Lorsch et al. quote a director of a giant financial services company, "[Two banks]--I think they crashed and burned. Neither one of them had anybody that I could detect on the board that's had any serious financial skills. And doesn't look to me like these boards demanded to know what was going on off balance sheet." Another director at the same company questioned management's financial acumen as well. "The bank boards and the bank CEOs and leadership, obviously, with the exception of maybe one or two, did not understand the risks they were managing." Again, it's not a problem of risk management process, it is a lack of care and competence.

Executive pay in these sectors was a symptom of the overreaching, overly coddled CEOs controlling passive boards, which the board members themselves admit, as above. Focusing on pay without focusing on regulating the creation, distribution, marketing, trading and accounting for toxic ("innovative") financial products is a futile exercise.