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Wednesday, February 11, 2009

The problems of capping top executive's pay

Incentive matters.  Here is a look at potential problems of capping executive's pay proposed by the new President.  (source:WSJ)

The Obama administration had to do something. But capping executive pay at $500,000 at banks needing "exceptional assistance" could make as many problems as it solves.

First, it could distort labor markets. Employees and executives will be tempted to flee troubled banks to subsidiaries of foreign banks or stronger U.S. institutions. That could make the weak even weaker.

Second, the plan caps pay for top employees. It doesn't yet address the arguably more important issue of generous pay structures lower down in organizations. The cap could encourage those in, say, better paid jobs running big departments at an investment bank to shun top positions where pay would be limited.

True, the limits aren't rigid. Large amounts of restricted stock could still be issued, although this would have value only if executives could dig their banks out of a deep hole and pay back taxpayers.

Third, the rules aren't retroactive. So AIG, theoretically, can bumble along, while a company getting into such trouble now would be subject to tougher rules.

On the positive side, the plan does encourage banks to pay back government aid as quickly as possible, even if it means tapping public markets at expensive rates. But even that could create a distortion. Those who took special assistance early, such as Bank of America and Citigroup with their loss-sharing agreements, would be under less pressure to refund that help early.

Not for the first time, the most incompetent, who hit trouble first, could end up relatively better off. Contrast creditors who had exposure to Bear Stearns -- who were made whole -- with those exposed to bankrupt Lehman Brothers.