03/19/2013 05:01 pm ET Updated May 19, 2013

Break Up Executive Pay, Not the Banks, to Fix Too-Big-to-Fail

Here are three business facts: 1) corporate profits are exploding and the stock market is soaring but most of this wealth is accumulating only to the wealthiest Americans; 2) despite intensifying pressure to break up the big banks, the U.S. government is hesitant to act and; 3) Europe is considering stringent new measures to curb out-of-control executive pay.

Taken separately they are just news headlines but considered together they might contain a cure for the worst disease infecting our economy today: too-big-to-fail.

Income Inequality

Rising corporate profits are obviously good since they mean more hiring, better wages, and more wealth. The problem, however, is that most of that money is being siphoned off into the personal coffers of top management while rank and file employees see little of it. It is also worth remembering that people on lower rungs of the ladder rarely receive equity as executives do, limiting their participation in their company's good fortune.

Not that outsized executive compensation or income hijacking are anything new but they are getting progressively worse. Fortune 50 CEOs today make 379 times the average worker, 22 percent of all income accumulates in the hands of the top 5 percent of earners; and the numbers continue to go in the wrong direction.

While this problem exists across industries, it is particularly bad in the banking sphere -- partly because of the sums involved but even more so because the same low- and middle-income workers who fail to benefit from profit rallies are also the taxpayers who foot the bill when those banks go under due to excessive risk-taking. The irony here is not just extreme but unconscionable.

Breaking Up the Banks

A popular solution is to break up the big banks, but of course that will do nothing to narrow the compensation gap, and nor is it guaranteed to work. There is some truth to Attorney General Eric Holder's recent statement that tinkering with too-big-to-fail banks could lead to financial chaos since those banks are entrenched in every aspect of the global capital markets.

Untangling the internal setup of a major bank and separating out its parts are far from easy and the results of such surgery far from predictable. Capital and business routinely flow back and forth throughout the system and often depend on the synergies that only an integrated organization can provide. Unless we have a surefire way to unwind the banks in a hurry, the smartest move is to nudge or incentivize banks like JPMorgan Chase and Citigroup to gradually become leaner and let them do it over many years to avoid upsetting the entire apple cart.

In the meantime, however, there is a better way to discourage risk-taking on the part of our banks, and that is to attack it from the angle of executive pay.

Executive Pay

The reason that banks need to be bailed out is not simply because they are in multiple lines of business but because they are in risky lines of business like proprietary trading, and are bad at managing those risks. Unfortunately, the current executive compensation system exacerbates this risk. While in theory the system pays people for responsible decision-making, in practice it rewards executives for generating outsize returns even at the expense of the company's future. Bonuses are rarely based on a long term view but on short term profits and meeting quarterly earnings estimates, which encourages CEOs and other senior managers to gamble big and to eschew singles and doubles in favor of swinging for the fences every time.

Consider some of these executives who made a killing from making just such bets but whose bad decisions backfired for almost everyone else:

  • Lehman Brothers CEO Richard Fuld was paid more than $500 million from 1999 to 2007, and
  • Countrywide Financial chief Angelo Mozilo made more than $400 million in the same period.

Both these men destroyed their banks (and the wider economy) by betting on extremely risky subprime mortgages. More recently, Citigroup shareholders got a raw deal when former CEO Vikram Pandit received a $15 million pay day even though the bank's share price fell by 44 percent. And that's not all; Citigroup also paid Pandit $165 million for his personal share of the hedge fund Old Lane Partners, which was subsequently shut down and resulted in a $202 million writedown for the bank!

These and other examples are all symptoms of a pay culture that has become increasingly disconnected from reality: executives have no incentive to do anything but take reckless chances because that is where the big money is, and because even when things go wrong, they personally lose very little (if anything).

To fix this, the basic incentive structure that rewards people for behaving badly must change. Imposing reasonable limits on executive pay and basing it on long term value rather than short term profit is the only way to eliminate the "quick buck" mentality and consequently rein in the risk-taking nature of our banks.

That, in turn, is what will really protect us from too-big-to-fail.

Europe seems to have realized this and is actively taking steps to ensure that runaway compensation does not jeopardize the future of companies. The Swiss, for example, have announced a referendum on a law that would enable shareholders of Swiss-based public companies to cast binding votes on compensation for executives and directors. It would also prohibit signing and exit bonuses and require more transparency from large investors like funds. This is a smart move that puts greater power into the hands of ordinary shareholders and enables them to take control of (and responsibility for) the future of their investments.

In America, shareholder votes on executive pay are non-binding and almost useless in convincing Boards to do anything. Moreover, CEOs and Board members are often beholden to each other due to their presence on Interlocking Boards and Compensation Committees, creating massive conflicts of interest. Vikram Pandit's compensation despite shareholder opposition (as well as the deal he got for selling Old Lane -- which was facilitated by his old friend Robert Rubin) and Dick Grasso's alleged arm-twisting of the NYSE Board to secure his $190 million bonanza illustrate this problem vividly.

There are many possible mechanisms to rationalize executive pay, including tying the compensation of highest paid executives to a multiple of the wages of lowest paid workers, creating holding periods for bonuses to assess the long term impact of business decisions, enforcing clawbacks vigorously, eliminating golden parachutes, and cracking down on conflicts of interest for CEOs and Board members.

Most of these can be executed without government intervention but some, such as making shareholder votes on executive pay binding, require new laws. Dodd Frank was a step in the right direction but we need more. No matter how talented an executive, his or her compensation should be based on how much value they add to a company's business fundamentals and not on their ability to place wild bets with other people's money.

That will not just be fair and lessen pay irrationality, but will help curb the risky behavior of our banks. Too-big-to-fail may never disappear altogether but if we can reduce the chances of failure by not rewarding executives for the wrong things, I predict that the system will be a lot safer and the need for bailouts much less likely.

SANJAY SANGHOEE has worked at leading investment banks Lazard Freres and Dresdner Kleinwort Wasserstein as well as at a multi-billion dollar hedge fund. He has an MBA from Columbia Business School and is the author of the financial thriller "Merger" (available below) which Chicago Tribune called "Timely, Gripping, and Original". Please visit his Facebook Page Candid Politics & Business Blogs for more content.