Should the G-20 Adopt Bonus Limits?

When the leaders of the G-20 meet in Pittsburgh on September 24, one of the key topics will be limits on bankers’ bonuses. This will be a highly contentious issue for the leaders of the world’s largest economies.

In late August, 2009, French President Nicholas Sarkozy proposed bonus caps for individual financial executives and a mandatory deferral of payment on 50% of such bonuses. While Sarkozy has implemented these proposals in France, he was rebuffed by the Finance Ministers of the G-20 in early September. They favor a proposal to limit the total amount of bonuses paid by a bank to a fixed portion of its income.

In my view, fixed limits on bonuses for individual bankers are likely to boomerang by leading to high guarateed salaries. But limits on overall compensation at unprofitable banks make sense if combined with share awards based on performance.

In February of 2009, Congress adopted legislative limits on bonuses of senior executives at financial institutions receiving federal assistance (Assisted Institutions). In specific, Congress limited their annual bonuses, or any other type of incentive awards, to grants of restricted shares of Assisted Institutions not exceeding one third of annual compensation.

These legislative limits on individual bonuses have already led to much higher annual salaries at Assisted Institutions. For instance, Wells Fargo raised the base salary of its CEO from $900,000 to $5.6 million. More broadly, Morgan Stanley increased by 250% the base salaries of its four top executives just below its CEO.

Thus, despite the best of intentions, these legislative caps have unlinked executive bonuses from executive performance. By raising base salaries, these institutions are effectively guaranteeing some or all of what used to be a variable payment contingent on that executive’s performance. This is a perverse result, undermining years of efforts by investors, academics and others to tie executive pay more closely to company performance measured over a reasonable time period.

In response to these concerns, the Finance Ministers are pushing for an overall limit on bonus payments by banks to a specified percentage of their income. Although this proposal should not apply to healthy banks, a modified version makes sense for unprofitable banks.

In a profitable bank, the portion of income going to executive bonuses comes from the pockets of its shareholders. As long as the bank fully discloses the amount of these bonus payouts, shareholders can decide whether these payouts represent a reasonable allocation of the bank’s income. Shareholders have been willing to invest in a bank with relatively high bonuses if they see significant earnings growth – the pie is expanding for everyone.

In an unprofitable bank, by contrast, the national government and the bank’s bondholders should be interested in its bonus payouts as well as its shareholders. But there is no easy answer. On the one hand, high bonus payouts will deplete the bank’s scarce cash and possibly imperil its solvency. On the other hand, low bonus payments may drive away the talented executives needed to bring the bank back to profitability.

Balancing both objectives, I would recommend that the unprofitable bank distribute modest cash bonuses now to top executives, together with large awards of restricted shares that will vest over the next few years if the bank returns to profitability. In addition, to avoid massive increases in base salaries for many employees, there should be limits on overall compensation for unprofitable banks – based on their revenue since their income is negative. This combination would incent talented executives to stay and turnaround the bank, while protecting the interests of the government insurance fund and the bank’s investors.

What do you think of this idea? Do you favor legal limits on individual bonuses of senior bankers or aggregate bonuses at an unprofitable bank?

Bob Pozen is a senior lecturer at Harvard Business School and the author of Too Big to Save? How to Fix the US Financial System (John Wiley, to be published on November 9, 2009)