Discussions and proposals on reining in the excesses of the financial system remain active. The last few weeks saw an announcement by the Federal Reserve targeting executive compensation as a component of its plans for financial reform, along with discussions about reducing the financial system's exposure to firms that are "too big to fail."

While there is some logic underlying the various proposals, most of them skirt important fundamental issues. For example, the stated logic underlying proposed pay limits is that compensation agreements based on profitability created incentives for firms to take "excessive" risks. However, firms have been paying (and overpaying) their executives on this basis for decades. (I distinctly remember a Wall Street Journal article from the early 1990s that approvingly compared the pay of Bear Stearns' executive committee to the salaries of the NBA Champion Chicago Bulls' starting five.) What changed over the years was the steady deterioration of financial firms' management practices and their managers' inability to institute and maintain effective controls. At the time the Journal article was written, Bear's management had a reputation for meticulous risk management. This clearly began to break down well before the 2007 collapse of its hedge funds initiated the firm's collapse.

A similar myopia comes into play in discussing the concept of "too big to fail." Some have proposed breaking up the large financial firms, questioning whether such firms create inordinate risks for the financial system. However, there are compelling reasons that financial markets encourage the growth of large firms. As confidence is the glue that holds the financial system together, banks and investors need to know that their counterparties are solvent and sufficiently well-capitalized. The Fed recognizes the link between size and solvency by instituting minimum capital requirements for primary dealers. The opposite of "too big to fail" is "too small to survive." A fragmented financial system comprising small, undercapitalized firms is doomed to frequent disruptions and panics.

Both the size and the compensation practices of financial firms were secondary factors in the financial crisis. Rather, the disruptions of 2007 and 2008 resulted from colossal and systemic management failures. In my opinion, the lack of board-level supervision and oversight of the large financial firms was a key contributor to the near-collapse of the system. Their directors were ultimately responsible for failing to impose management structures that controlled enterprise risk (including on- and off-balance-sheet assets) while allowing for aggressive opportunism.

A key objective of financial reform should therefore be to make financial companies' boards stronger, more active and more independent. As the boards have the power to award extraordinary compensation, they must also have the authority, competence and willingness to monitor the firms' risks and to institute prudent practices. As a start, the way directors are elected to the boards of financial firms should be rethought. Having a board that is "hand picked" by management is exactly backward. Rather, the directors of large financial firms should be nominated by, and answerable to, their regulators. This is consistent with the recognition that financial firms have the financial system as a primary constituent, with interests superior to those of their shareholders and creditors.

These changes would have a more profound and permanent impact on the financial system's safety and soundness than the proposed limits on bankers' compensation. Attempting to directly regulate pay, while appealing politically, would only trigger the creation of alternative compensation schemes that skirt the regulations without addressing the underlying management issues. Effective and comprehensive reform will rather address the failures of oversight that allowed bankers to pursue outsized pay in the absence of prudent limits.

Bill Berliner is a consultant based in Southern California. His Web site is www.berlinerconsulting.net

(c) 2009 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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