Many causes of the financial crisis are obscure to the man on the street. But the one aspect that is easily understood — yet entirely unconscionable on Main Street — is that industry players are paid handsomely despite their failures. As a result, the financial services industry’s compensation practices are coming under siege, as both firms and policymakers struggle to get a grip on this aspect of the global crisis.

In recent years, no industry has paid as handsomely as financial services. And shareholders were content to pay out huge compensation packages to top traders and senior executives because the growth in earnings was so impressive. Now, however, the model is in disarray. The fallout from the credit crunch and the ensuing writedown of assets have hammered earnings. In many countries, the damage has been severe enough to warrant government intervention, which, in turn, has produced pressure to reform compensation structures.

So, industry compensation has become an issue on two levels: one, it is believed that compensation practices helped foment the financial crisis; two, the size of industry pay packages amid apparent failure and government intervention has ignited public outrage.

The rising tide of public anger was captured by U.S. President Barack Obama, when he addressed the issue of executive compensation, calling the payment of large industry bonuses amid the financial crisis “shameful” and characterizing it as “the height of irresponsibility.

“We don’t disparage wealth,” he said. “We don’t begrudge anybody for achieving success. And we believe that success should be rewarded. But what gets people upset — and rightfully so — are executives being rewarded for failure. Especially when those rewards are subsidized by U.S. taxpayers.”

That same intolerance to prevailing pay practices is evident in Britain, too. The country’s regulator, the Financial Services Author-ity, notes in its latest assessment of market risks that although it is difficult to prove a direct causal relationship between industry pay practices and the market crisis, there is widespread belief that those practices were a contributing factor. The asymmetric incentives provided by industry compensation practices effectively served to thwart effective risk management, the FSA report observes.

“In many cases, remuneration policies were running counter to sound risk management, effectively undermining systems that had been set up to control risk,” the FSA report says. “To support prudent risk management, the incentive structure in compensation practices must be compatible with risk management and controls and not encourage excessive risk-taking.”

The FSA report warns that risks reside in compensation practices that: rely too heavily on performance measures such as revenue and profits and don’t take sufficient account of risk; don’t consider non-financial factors, such as compliance with company ethics and attitudes to risk; and are dependent on large cash bonuses that are paid out immediately.

The report also flags governance arrangements in which internal departments that focus on issues such as compliance and risk management don’t provide input on compensation plans.

While the immediate circumstances of the global financial crisis have brought the problems of skewed incentives and one-way compensation packages to light, it may be that the quantum of pay is also distorted. According to a paper published by the U.S. National Bureau of Economic Research — authored by Thomas Philippon and Ariell Reshef, professors from New York University and the University of Virginia, respectively — financial services industry compensation has been overinflated by 30%-50% in recent years, compared with the rest of the private sector, the result of financial services industry employees’ ability to capture “rents” from their firms and shareholders.

The NBER paper also uncovers a “very tight link” between regulation and financial services compensation. It finds that as regulation eases, the sector enjoys an influx of highly skilled workers, driving up wages. Conversely, when regulation is tightened, clever workers forgo financial services for careers in other industries. “This suggests that regulation inhibits the ability to exploit the creativity and innovation of educated and skilled workers,” the paper says. “Deregulation unleashes creativity and innovation and increases demand for skilled workers.”

At the same time, such trends create a vicious cycle that hampers regulators’ ability to sniff out a growing financial crisis. De-regulation that makes a financial career more attractive to creative, innovative workers and, therefore, raises industry wages, also serves effectively to price regulators out of the labour market.

@page_break@“Following the crisis of 1930-33 and 2007-08, regulators have been blamed for lax oversight. In retrospect, it is clear that regulators did not have the human capital to keep up with the financial industry, and to understand it well enough to be able to exert effective regulation,” the NBER paper says. “Given the wage [premiums] that we document, it was impossible for regulators to attract and retain highly skilled financial workers, because they could not compete with private-sector wages.”

After all, if pay is both a proxy for skill and an incentive for extraordinary performance, how could an investigator earning less than $100,000 a year be expected to ferret out the misdeeds of someone who commands millions?

Indeed, one idea that was proposed at this year’s annual meeting of the World Economic Forum in Davos, Switzerland, was the notion of ramping up regulators’ compensation or paying significant bonuses for exceptional regulatory performances, such as unearthing major frauds.

For this to work — at least, in a Canadian context — the regulatory structure would first have to be rationalized. Otherwise, regulators would find themselves competing against one another and ratcheting up the price of regulatory talent. Moreover, regulatory fees would probably have to rise to fund the increased pay scale — surely an unappealing prospect in the current market environment.

While this kind of change seems highly unlikely in the Canadian financial services industry today, if the effort to create a single regulator proceeds as the federal government hopes, there will be an opportunity to implement a new compensation scheme that could enable regulators to compete more effectively for skilled workers.

Indeed, the Hockin report calls for market-level compensation for staff of the new single securities regulator: “To attract the right people, staff compensation needs to be competitive, reflective of the compensation provided in the private sector for equivalent skills and experience.”

Moreover, a central principle of the proposed new national regulator is the adoption of rigorous performance measurement — which, presumably, could be used to inform a more incentive-driven compensation structure.

In the meantime, the financial crisis is effectively narrowing the pay gap between the regulators and the regulated, as the value of that so-called “financial innovation” wrought by creative employees comes into disrepute. If, in fact, the gains that financial engineers generated are largely illusory, then industry firms aren’t going to pay handsomely for them. Besides, firms are now focusing more on reducing risk than developing the next great financial novelty, further reducing the demand for such workers.

In response to the financial cri-sis, regulators will probably tighten oversight in many corners of the financial services industry, which also does not bode well for industry compensation. Simply suffering a crisis is not enough to depress industry wages, the NBER paper found; rather it’s the regulatory reaction to a crisis that dictates whether wages rise or fall.

“The occurrence of a crisis, high unemployment, bank failures or a long bear market have no predictive power for relative wages and skills employed in finance,” the paper says, “while regulation does.”

So, as restrictions on financial services businesses multiply and oversight intensifies, rewards can be expected to fall, too.

But that declining compensation assumes policymakers don’t intervene directly in pay practices, which is something being considered in some jurisdictions.

In Britain, for example, the government is reviewing corporate governance in the banking industry, focusing largely on recommendations to improve risk management, including the provision of incentives in remuneration policies to manage risk effectively, and improving the performance of compensation committees. The review panel will deliver its preliminary conclusions by the autumn, with the final recommendations due by yearend.

The U.S. government, meanwhile, is imposing a variety of restrictions on executive compensation at firms that require government assistance to stay afloat, including limiting top executives’ annual salaries to $500,000 and requiring that any additional remuneration be in the form of restricted stock that vests only once the government has been repaid. The government is also: asking those firms to adopt non-binding shareholder votes on executive pay (say-on-pay provisions); limiting golden parachutes (nothing for the top 10 executives, and just one year’s pay to the next 25 execs); imposing clawback provisions; and requiring that boards review luxury expenditures such as the use of private jets, pricey office renovations and lavish parties.

The U.S. Treasury also promises to arrange a conference to seek ideas for establishing best practices in executive compensation arrangements at financial services institutions.

Some firms are already making changes to their compensation systems. Late last year, Swiss banking giant UBS AG adopted a “bonus/malus” system that keeps top executives’ variable compensation at risk for several years; those executives will see compensation vanish if future performance warrants a malus rather than a positive payout.

Things are changing on Wall Street, too. John Mack, CEO of Morgan Stanley Inc., said in his testimony to the House financial services committee that his firm has reformed its compensation structure to include clawback provisions that will enable it to recover compensation from employees who have engaged in “detrimental conduct” or caused large losses at the firm. Mack also noted that his firm is also now tying compensation more closely to its performance over several years.

In Canada, where bank earnings have been hampered by exposure to troubled assets but no government funds have been used to prop up the banks, some bank CEOs have made goodwill gestures in light of the current economic conditions and given up some of the pay awarded by their boards. (See story above.)

These decisions to pass up a great deal of pay can be viewed as either politically savvy or simply honourable actions in the face of the ongoing financial crisis. But whatever the motivation, they highlight the weakness of corporate governance, as it’s the CEOs themselves telling their boards that their pay is excessive. Surely, if boards and compensation committees were working as intended — on behalf of shareholders — they would have reached these conclusions for themselves.

Ultimately, the practices that need to be adopted aren’t any great mystery: reward systems need exposure to both the upside and downside of company’s performance and a longer-term perspective. The prevailing schemes often reward bankers, traders and executives on the short-run upside, but don’t expose them to the long-run downside.

However, crafting such structures without creating other unintended consequences is surely easier said than done. IE