Yet another faulty banker pay scheme to avoid by Eleanor Bloxham @FortuneMagazine July 2, 2014, 11:54 AM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons What do you think about texting and driving? And what would you think if Harvard academics were advocating it, and some cops on the beat were considering going along? To put your mind at ease, they aren’t—but something analogous, and potentially more disastrous—is happening in the world of banking. In a speech in June, Daniel Tarullo, a member of the Board of Governors of the Federal Reserve, spoke glowingly about “corporate law scholars” and referenced a compensation program advocated by Harvard law professors Lucian Bebchuk and Mark Roe that would require big banks to pay executive bonuses with the bank’s own bonds. FDIC Vice Chair Tom Hoenig and Anat Admati, a Stanford professor of law and economics, are already concerned about the current size and debt levels of the largest banks. But such a program could also require large banks to issue long-term debt, convertible into equity, with the effect that “too big to fail” banks could become potentially even larger and more leveraged than they are today. The danger with paying executives in stock or bonds is that these incentives take executives’ eyes off the risks that they should be managing. Revved up compensation plans built on stock payouts motivate excessive risk taking at financial firms. Think about the stock-dominated package of former Lehman Brother’s CEO Dick Fuld, who was listed on Time Magazine’s 25 People to Blame for the Financial Crisis. And think about the lack of attention to mortgage servicing operations in the crisis’ aftermath. Would bonds do better? Why not just pay executives in cash, assuming they deserve it, but with restrictions? Bebchuk, Roe, Tarullo, and New York Federal Reserve President William Dudley did not respond to requests for comment. When shareholders advocated that executives be paid in stock, the idea was that it would encourage them to think and act like shareholders—and thus behave in ways that would benefit shareholders. Bebchuk offers similar reasoning in his push for the use of bonds. Perhaps if at least some of executives’ pay is tied to bonds, they’ll think like creditors the reasoning goes. But the unsavory outcomes of paying executives with company stock have debunked notions that similar schemes can help managers act or think like people with similar financial stakes in a firm. Managers will act to maximize their own particular interests, and they may take short cuts to do that. Remember Enron, WorldCom, the options backdating scandal, and the financial crisis. In addition to getting executives to think and act like bondholders, Tarullo hopes that by issuing more debt at the largest banks, creditors will motivate better governance in ways that shareholders and regulators haven’t been able to. The notion that you can use the market discipline of shareholders or creditors to supplement regulatory oversight is not new. I was asked to speak at an FDIC conference over a decade ago on whether market mechanisms could be used to improve bank oversight. But banking is an opaque industry. It lacks the kind of transparency shareholders and creditors need to discern the real risks going on beneath the surface. Frankly, some of what is done inside banks has become so complicated that bankers themselves don’t even know what is boiling in their cauldrons. And there are other problems, too. Just as compensation in stock can provide bankers with motivation to hide risk, payment in bonds can do the same. If bankers obfuscate the risks on their balance sheets, their bonds would earn a higher credit rating. Such an action has its fair share of precedent. In the recent financial crisis, some bankers pressured rating agencies for high scores–and hid from buyers the risks in the bundles of loans they were selling. Bill Black, a former regulator and now an economics and law professor at the University of Missouri, says bonds don’t answer the issues with banker compensation today, citing the motivation it provides bankers to manipulate the credit ratings processes as just one reason such practices are ill-advised. “Bonds as compensation are a non sequitur,” he told me. “Every aspect of compensation today at banks is contrary to what they should do. It has nothing to do with helping the company but everything to do with helping the CEO—especially the worst CEOs,” Black says. Black advocates for a smaller base pay of $300,000 or less for the CEO—and a large payout if they can prove success for eight years or more. Even then, Black says companies should claw back that compensation if the payouts were unwarranted. Dean Baker, an economist and co-founder of the Center for Economic and Policy Research, says that paying bankers with bonds is flawed because bond prices are based on “interest rates and the economy” and it’s absurd to pay bankers based on factors that they should have “no control over.” The incentive to manipulate interest rates is also a concern. (Bond prices are inversely correlated with interest rates—they rise when interest rates fall—and vice versa). In March, the FDIC sued 16 of the largest banks for manipulating an interest rate called LIBOR,which contributed to significant losses at 38 other banks that went into FDIC receivership. Nor do we want banks to be less transparent than they already are. Banks can easily “manipulate their balance sheets” to tell a particular story, Baker says. Bank financial statements are very “sensitive to the accounting” they choose to use—and we don’t want them hiding risks. That’s “180 degrees opposite of what we want them to do.” So that taxpayers don’t end up on the hook again, Hoenig is persuasively advocating for stronger, more detailed living wills for banks—and both Hoenig and Black have been recommending better examiner oversight at the largest banks so managers and regulators can better understand the risks and, hopefully, avoid the worst. Instead of paying bankers with bonds, regulators should require financiers to focus on risk-adjusted measures of performance that managers can control—and reward them on that basis. Banks should also hold back bonus payouts for longer periods of time. And, finally, these institutions should wipe out potential bonuses should they get anywhere close to requiring governmental resolution. Rather than abdicating their responsibilities to clueless markets, regulators could easily use any combination of measures—like the results of improved exams and stress tests, more robust living wills, liquidity triggers, and Camels ratings (regulatory scores of risk)—to determine when potential bonuses should be erased. Four years ago, when I wrote about Bebchuk’s idea to pay bankers with bonds, he didn’t respond to requests for comment—nor has he responded to requests on the subject in the intervening years. Since then, the largest banks have grown larger and by some measures riskier. Before regulators like Tarullo paper over too-big-to-fail with another half-baked solution, it’s time for legal scholars and regulators to address concerns with their proposals. If they won’t address these criticisms openly, why should we believe what they say? Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance. She may be reached at firstname.lastname@example.org.