Populism and Compensation Don’t Mix

One of the provisions for receiving government funds through TARP caps executive salaries at $500,000.  Companies argue that setting caps in that way leads to a talent drain – top employees who can receive a greater salary elsewhere will go do that.  These predictions are coming true; TARP companies are losing talent to boutique firms that don’t have compensation limits.  Is this the best effect on companies trying to pay back public money?

Top Talent, Top Dollar

The number one problem with the populist anger that inspired the TARP salary

Get Away from This... from Mrs. Gemstone
Get Away from This… from Mrs. Gemstone

restrictions is the lack of accuracy.  People are angry with companies such as Citibank and Bank of America that took money from the Troubled Asset Relief Program.  The problem is a few isolated groups caused the vast majority of those losses.  These companies are giant multinationals.  The groups that will lead the companies back to financial stability are different from the groups that drove them away from it.

TARP salary limits hit the executives in companies like Citi across the board.  MBS (Mortgage Backed Securities) group executives receive the same pay caps as bond trader executives.  The lack of accuracy in applying salary caps affects all of these groups.  The other issue is the best performing executives in hurting groups will also have incentive to leave.  The result?  A ‘brain drain’ to smaller, related firms, which don’t have restrictions and aren’t under the government’s microscope.  The bottom line is pay caps won’t work.

Shifting Practices

Markets, including the market of compensation, will shift under the weight of legislation.  TARP pay limits have also caused new practices since being put into effect.  Companies under this limit have shifted their pay practices to get around the language of the limits.  To avoid the appearance of ‘too large’ bonuses, companies are increasing the base salary of employees.  Employee pay at large companies has become a political – not a financial – question.

The pay caps have also contributed to the decisions of some of the better off companies to pay back their portion of the TARP funds.  This obviously can be framed as a good thing… the Treasury (read: taxpayers) has made money off the payback of these funds, and the political cover of lumping stronger banks with the banks that needed an influx of funds is no longer needed.  Unfortunately, all of these effects come at the expense of those weaker banks.  And, of course, choosing to bail banks out in the first place avoided (or maybe just delayed?) ‘creative destruction‘, an important benefit of capitalism.

What Not to Do

If companies sign a contract, it’s their own issue if the terms of that contract are onerous.  If the terms of the contract change after the contract is signed, that’s a different issue altogether (and now that this precedent has been set, new banks can avoid TARP).  However, if the banks were somehow forced into TARP, it’s a totally different issue.    Changing the terms of contracts after it is signed or forcing parties to sign a contract is a major violation of trust.

The government’s interference in the pay practices of private companies after TARP funds were already shifted has caused bad blood between financial firms and banks.  If something has to be done to reign in financial risks and better align the compensation practices of banks in turn, let’s look to market solutions to market problems.  If we want to have this debate as a country, let’s discuss it in detail and consider the unintended consequences.

Financial District image sourced from www.flickr.com/photos/50624154@N00/2371374317, shot by ForsterFoto.