Friday, February 6, 2009

Salary Caps and The Brainless Voting Mob (The Sequel)

Kyle raises an important point in his comment on the previous post, which incited me to ponder the issue a bit more in depth for the benefit of my readers. First to reply to Kyle, who wrote:
If an employee's cash payment is capped, but his overall compensation package is constant, then these guys get paid stock options. So, while you're right in that their total pay won't be changed, their interests will align more with the company's future, which in theory could be a good thing.
While theoretically, this should hold, there are a few mitigating circumstances. For one, stock really only provides incentives if it isn't a gratuitous grant. If the CEO doesn't feel like he's earned it, he'll treat the stock like a windfall, and not like an investment. The phenomenon is similar to people who win the lottery, and then blow it all in a year. I've spent about nine months studying CEO compensation in the banking industry, and I've found that "long-term" compensation, by itself, completely fails to spur long-term strategic thinking. Obama's pay caps simply hamper boards' ability to compensate for long-term results.

This brings me to my second point. At all but the largest banks, stock constitutes a less important portion of total pay. Cash incentives, both short-term and long-term, play a larger role, as this WSJ article points out.

Regional banks, which are one notch below the big nationals like JPMorgan Chase and BofA, stand to be hurt the most if this rule is expanded to encompass them. Several of these banks employ some kind of long-term incentive program, which uses a combination of cash and equity grants to reward executive for achieving or exceeding preset multiyear performance goals. This is the best compensation measure I have found, because it holds the executive to objective standards, as well as forces the board to specify exactly what kind of results it expects from management.

I am not sure if the Obama plan's loophole for "other long-term compensation" allows for this component (If it does, the plan will have even less effect than I previously thought.) If it excludes this type of plan, the consequences to those banks who know how to use cash compensation effectively will be dire.

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