Vive la France—and Germany, Too

09/17/2009 2:16 pm EST

Focus: MARKETS

Howard Gold

Founder & President, GoldenEgg Investing

Updated Friday, September 18th

France is one of those countries many Americans just love to hate.

America's ally against the British in the early days of the republic has become a symbol of everything we don't want: a paternalistic welfare state with protectionist economics and a resistance to change so deep the slightest withdrawal of social benefits sends people into the streets to shut down railroads, airports, and other vital services until the government ultimately capitulates. Quel dommage!

But now I would say we owe the French—and the Germans—a debt of gratitude. French president Nicolas Sarkozy and Germany's chancellor, Angela Merkel, have led the fight for strong financial reforms, especially of financiers' compensation, which they rightly say was a central cause of the financial crisis.

While President Barack Obama and his Treasury Secretary Timothy Geithner have put forth some weak reform proposals and UK Prime Minister Gordon Brown has dithered as usual, Sarkozy and Merkel have pushed hard for months to put financial regulation and bankers' compensation at the top of the agenda. (The Federal Reserve now appears poised to adopt tougher restrictions on Wall Street pay on the eve of the G20 meeting.)

And it should be. Wall Street bonuses alone didn't cause the financial crisis; there were many, many culprits, as we've written here frequently. But the money machine that created, packaged, and sold securities based on horrendous mortgages that were doomed to fail was a critical part of the process.

Wall Street and the City of London and banks in Zurich, Paris, Frankfurt, and other financial capitals encouraged reckless behavior by US mortgage lenders and borrowers to fuel the gargantuan profits these banks made earlier this decade. The bankers' chief motivation, of course, was earning those fat bonuses. What happened later was someone else's problem.

The rotten and corrupt bonus culture has become so pervasive that even after the system nearly collapsed, saved only by hundreds of billions of taxpayer dollars, the fat bonuses kept coming, stoking understandable public fury. Clearly, reforming the compensation system to remove perverse incentives has become a critical issue. “Finance's risks are everyone's,” as the Economist put it.

Now, President Sarkozy and Chancellor Merkel's efforts—patronizingly dismissed early on—are starting to bear fruit, and we may see some real changes mooted at next week's G20 meeting in Pittsburgh.

The Financial Stability Board, composed of top financial regulators from 24 countries (including the US), will recommend to the assembled heads of state that compensation banks' pay out be temporarily limited until they comply with stricter capital requirements.

“It's important that firms conserve profits so they can rebuild capital and support lending,” the FSB's chairman, Mario Draghi, told reporters in Paris this week. “We will have a link between total bonus pool and the firm's overall performance.” Draghi is governor of the Bank of Italy and a former managing director of Goldman Sachs.

I'm surprised at how sensible this idea is and how much it would solve in one stroke. It would address the public's legitimate concerns about using taxpayer money to keep bankers in Lamborghinis and Cristal without getting the government too involved in private companies' pay practices. 

If you're a strong institution that's well capitalized, you probably won't need public assistance (assuming your risk-management practices are up to speed). So, you will have a free hand in paying your best people.

But if your company is still shaky and you are more likely to turn to the taxpayer to keep you afloat, then you cannot just dole out your profits willy nilly to bonus babies. You're going to have to use that money to build up your capital reserves first. 

(Tellingly, Lehman Brothers, the first anniversary of whose demise we mark this week, paid out some $5 billion in total compensation in the year before it failed—one third of its core capital, The Economist reported.)

If that means you lose talent to stronger competitors, then so be it. That's capitalism, isn't it?

And banking regulators are also pushing for much higher capital requirements, further separating the winners from the losers in finance.

Meanwhile, some financial firms, still reeling from the public's outrage, have quietly been putting their own houses in order. Morgan Stanley (NYSE: MS) and UBS (NYSE: UBS)—one of the worst offenders of all—have begun to alter their pay systems, under shareholder and government pressure.

Both have moved towards doling out bonuses over several years, and giving out more stock than cash. UBS also will pay out a higher fixed salary. Both Morgan Stanley and UBS limit the new pay practices to senior executives only, not top traders, commission-earning brokers or hotshot investment bankers. But UBS at least has said it would extend the policy to “risk takers” some time this year.

“Firms are deferring more compensation than they were a few years ago, than they have in the past,” says Alan Johnson, managing director of Johnson Associates, which advises banks on compensation issues. “Many firms would put in high base salaries which would take the whole bonus structure out of the equation.”

“People will make much less than they made in the heyday,” he concludes.

That's a good thing. I'm glad we're seeing some new initiatives from the firms themselves—and maybe even Goldman, the new poster child for compensation run amok, will make major changes.

And the FSB's proposal is a big step forward from President Sarkozy and Chancellor Merkel's earlier stands for a hard cap on bankers' pay or the truly terrible idea of singling out financiers' bonuses for heavy taxation, which has surfaced from time to time.

And sure, politics is involved. Chancellor Merkel faces an election within days, and criticizing “cowboy capitalism” gets points from German voters. And although President Sarkozy is far friendlier to the US than his venal predecessor Jacques Chirac, you won't lose support in France if you “epater les Anglo-Saxons.” (That means, roughly, sticking it to us and the Brits.)

But let's give credit where credit is due. In this matter at least, our often-irritating friends from across the Atlantic have done us all a favor—and they deserve a tip of the chapeau.

Howard R. Gold is executive editor of MoneyShow.com. The views expressed here are his own.

Related Articles on MARKETS