http://www.nytimes.com/2008/11/04/business/04sorkin.html?_r=1&ref=business&oref=slogin

Whoever is elected president on Tuesday, one hot-button issue from this long campaign will keep hounding Wall Street: executive pay.

Both Senators Barack Obama and John McCain
have criticized the seven- and eight-figure paychecks that Wall
Street’s top brass collected in recent years while driving their
companies — and the entire financial system — into the ground.

Both
candidates have said the heads-we-win, tails-you-lose pay schemes that
seem all too common in finance lie at the heart of the crisis that
threatens the whole economy. Even some senior executives have told me
that they agree.

Many people agree that the pay system is broken.
It is clear that rewarding executives for delivering a few quarters of
outsize profits or a share price that keeps rising (until it doesn’t)
only encourages those executives to take risks. And managing risks
hasn’t exactly been Wall Street’s forte lately.

The question
is, how should pay be fixed? Now that American taxpayers are
shareholders in the nation’s largest banks, a bevy of plans are making
the rounds.

Some in Washington want to cap pay, period. Executives can make only so much and no more.

Others
argue for “claw-backs.” That is, they want executives who got rich
while their companies were reporting fat profits to be forced to give
some of the money back. After all, much of the industry’s profits from
the boom have been vaporized in the bust.

And still others have even come up with fancy formulas to rein in pay.

The
issue has become such a nail-biter for big banks that some are even
considering curbing pay voluntarily. Top executives hope such a move,
coming in a year when pay is already plummeting, might quiet the
complaints.

It won’t.

While various plans are being
bandied about, one in particular deserves attention. It comes from
Raghuram G. Rajan, a professor of finance at the Graduate School of
Business at the University of Chicago and former chief economist at the International Monetary Fund.

Mr.
Rajan is a longtime critic of executive pay on Wall Street. But he’s
not a knee-jerk, all-big-bonuses-are-bad critic. Instead, he’s a pretty
thoughtful, pay-for-performance capitalist who has been studying ways
to create the right incentives for the system to work.

He has a
multifaceted approach that would give banks a choice. Under the first
option, the government would strictly regulate compensation formulas.
Under the second, banks could pay their executives whatever they like —
provided the banks set aside more capital. In other words, banks that
cling to their free-wheeling ways would have to pay some sort of price.

For Mr. Rajan, this is an either-or proposition. If banks pursue
current compensation policies — what might be described as the
“no-responsibility” system, given the trouble we’re in — that’s fine.

But
if that happens, “the government should levy more capital requirements
against the bank,” he said. Requiring banks to have higher capital
requirements would reduce the risk that executives will make stupid
decisions that imperil the firm and, possibly, the nation’s financial
health.

How much extra capital? That depends. If banks spread
out executives’ pay over, say, four years, giving their executives an
incentive to make smart decisions for the long haul, the banks would be
allowed to set aside a bit less additional capital.

Ditto if
they included claw-back provisions and required executives to reinvest
a substantial portion of their income in their companies so they had
some skin in the game.

“We need to make people a little more
worried about the future,” Mr. Rajan said. The way things are now,
executives are encouraged to take big risks because they get paid based
on the immediate fees generated. They have little incentive to worry
about what might happen to the balance sheet later.

Mr. Rajan
said he was unimpressed by efforts to pay executives partially in
stock. Owning shares in the entire company doesn’t tie bankers’
compensation directly to the decisions they make within their own
units. “Stock compensation doesn’t do it because it’s too broad,” he
said.

More important, Mr. Rajan wants executives to be paid over
a four-year period, receiving a fourth of their bonus income every
year. If they make a bad bet, they won’t get paid the remaining amount.

And
Mr. Rajan thinks bonuses should be based strictly on what he calls
“accounting performance,” rather than stock performance, which he says
you can’t control. He also wants chief executive pay to be benchmarked
against the performance of rival firms. If a firm’s earnings are worse
than their rivals’, “why should they get a bonus?” he asked.

Despite
all the criticism that hedge funds get for their compensation
structures — they charge one fee up front, and take a big cut of any
profits — Mr. Rajan likes part of the hedge-fund model: what is known
as a “high water mark.”

When hedge fund managers lose their
investors’ money, the managers don’t collect any of that fat incentive
fee until they make back the loss. The same rule should be applied to
bankers who destroy shareholder value.