by Sharyn O'Halloran
Amid much hue and cry about the $18.4 bn in bonuses paid on Wall Street for 2008 (even though this was down sharply from the $39.3 bn paid out the previous year), the president has announced compensation limits of $500,000 for managers of firms receiving TARP money. For the public, this will afford a temporary feeling of revenge on those who got us into our current financial mess.
For firms, it means a set of new constraints on how they can do business. The question is how to maximize subject to these constraints. How, that is, should the finance industry – which, after all, is still an important sector of our economy – adjust to these rapidly changing circumstances? Assuming that one can actually hold a conversation with an industry, I would suggest the following playbook.
1) Give the People What They Want
a) For most political leaders, not all, the issue is not the compensation per se. What they are trying to eliminate is the unholy trinity of waste, fraud and abuse that they now see as rampant in the financial industry, and, rightly or wrongly, blame for the financial crisis.
2) Re-write Your Own Rules
How do you rewrite the rules to meet best practices and at the same time not send the financial industry the way of the dodo (or accounting firms in the post-Enron era)? I have some ideas...
a) All financial institutions (bank holding companies, broker/dealers, hedge funds, wealth advisory firms, etc.) will be subject to registration and disclosure requirements.
b) Financial institutions managing more than $100 billion in assets will be subject to regulatory supervision under the Banking Holding Company Act.
c) Federal regulation will be divided along functional and product lines, independent of the type of financial institution (bank holding company, hedge, private equity, etc.) undertaking the activity.
d) Derivatives, Credit Default Swaps and other complex instruments will be traded on a regulated exchange. All Derivatives and Credit Default Swaps not directly linked to the asset held will be regulated by the SEC as a security and follow the same disclosure rules.
e) The sale and distribution of all securitized assets is to be accompanied by a mandatory due diligence report, based on a random sample of the underlying asset quality, to be published in a prospectus registered with the SEC.
f) Banks and loan originators are required to sustain loan recourse reserves of at least 15 percent.
g) Asset managers will not be allowed to clear their own trades, but must rely on independent third parties for execution with notification to the client (John Coffee's anti-Madoff provision).
3) Strategy: Run the Political Bases
Big boys crying foul, after they themselves broke the rules, will find their complaints falling on deaf ears. What to do?
a) Work the relevant House and Senate committee and sub-committee chairmen. Any legislation working its way to the legislative floor has to go though the mark-up process. This is the key veto point to hash out the details.
b) Focus on Democratic and Republican moderates; they hold the swing votes now.
· Remember, previous analysis of the bailout votes showed defection from the wings: both the liberal Democrats and the conservative Republicans failed to support the initial bill, and it was the moderates that pushed it though.
· Once again in the passage of the stimulus package it is the Senate moderates who are crafting the legislation.
c) Work the agencies
· Many of the changes in the playbook can be rewritten through executive rule-making.
· This is a preferable strategy as it minimizes the risk of extraneous provisions that can have unintended consequences.
· It also circumscribes the scope of the agency rulemaking to its specific jurisdiction.
4) Keeping Score
Rep. John Dingell (D-MI
a) Slough and Bait
· Compromise on pay limitations. Give public officials the visible win of cash caps and disclosure of executive perks in exchange for performance-based compensation. In fact, you may even do better.
· The stock appreciate rights (SARs) approach JP Morgan adopted is an interesting model moving forward.
· If explained correctly, this might strike the right balance between performance and reward while at the same time retaining the best and the brightest. (We face similar problems in academics, which we solve through a series of common pool benefits.)
b) Stay on Goal
· The real bite will come if regulators limit your revenue stream. For example, if they introduce regulations that prohibit the use of CDSs or Bank Holding Companies from both underwriting and providing consulting services or segregate consumer credit from commercial lending, etc.
· Anything that goes to the bottom line needs to be out-of-bounds. The rest is just a ride on the merry-go-round of regulatory reform; you may get a little dizzy, but no lasting damage.
c) Be a Good Sport and We All Win
· The best public posture is to acknowledge that there is a real need for more effective enforcement of and compliance with existing laws and regulations, which for the most part are adequate but unevenly applied.
· Working to improve the strength of the regulatory process will weed out the good companies from the less worthy.
Rewriting the playbook is never easy. Rule changes will clearly have implications for who wins and who loses. But strong, competitive firms can always adapt. It requires financial industry leaders to think not only about current sources of revenues but where future opportunities lie. But this is what good managers making $500,000 a year are paid to do all the time. Let’s play ball!