J.P. Morgan's debacle: It's time to talk exec pay

June 14, 2012: 9:12 AM ET

In all the hullabaloo and consternation about J.P. Morgan's oversized bets, we have glossed over the elephant in the room: executive pay at banks is in need of a major makeover.

FORTUNE -- In The Devil Wears Prada, Meryl Streep's character Miranda Priestly says she lives on hope. I know what she means. But sometimes, I wonder how long we can live that way. We keep paying for the bank's messes. We pay for the government hearings and investigations, the losses in our retirement accounts, the negative impact on the economy, and in many other ways.

J.P. Morgan (JPM) CEO Jamie Dimon testified before the Senate Banking Committee this morning. But in all the hullabaloo and consternation about the bank's oversized bets,  only a minute or two was spent on incentives. Sure, J.P. Morgan's proxy has something to say about pay and risk. The company is required to address such things now. And what it says is that "regardless of the motivation," the bank's "risk discipline" and "frequent risk reporting" has "excessive risk-taking" under control. Well, that didn't work so well at Fortune's most admired megabank and No. 22 most admired company in the world.

Despite what Dimon said this morning, it's important to remember this is not an isolated mistake. Bloomberg reported last week that a court appointed monitor is seeking  consumer input related to ongoing foreclosure abuses. And the senators at the hearing asked for help for constituents that are being told their paperwork is missing. To his credit, Dimon said the bank would look into the paperwork issues.

But poor oversight is a management and governance deficiency. The billions of dollars in trading losses is merely the most recent example of poor risk oversight at the largest banks

On May 10, J.P. Morgan disclosed its immense trading losses. But on April 6, a hedge fund manager told the Financial Times: "The thing I'd be questioning, though, is why JPMorgan has such a big directional position when banks aren't supposed to be prop trading any more." And Bloomberg reported on April 9 that "four hedge-fund managers and dealers say the trades are big enough to move indexes and resemble proprietary bets, or wagers made with the bank's own money." If outsiders understood the size of the gambles back then, where were the bank's senior managers and its board? Why on April 13 did they not understand the magnitude, as Dimon testified this morning was the case?

MORE: Dimon hearing raises questions about risk models

When I speak with board directors, risk managers, and consultants who work with some of the largest banks, they agree that there is still a lot of work to do when it comes to risk oversight. And if Congress wanted to get the real picture, that's who they'd be talking to -- along with other observers who know the score. Not that everyone would be forthcoming, but if Congress asked the right questions, they would get the facts about the bailed out banks soon enough.

Exec pay days, for all the wrong reasons

But let's focus instead on motive and the all too obvious fact: incentives matter. If you pay for the wrong reasons in the wrong form, you'll get the risky behaviors you encourage. We shouldn't be surprised.

Jamie Dimon became CEO of J.P. Morgan on January 1, 2006. The latest J.P. Morgan proxy shows that Jamie Dimon holds shares (and equivalents) worth over $200 million based on the company's closing price June 8. If the stock price rose to where it was just five years ago, his net worth would jump by $75 million.

A similar pop would net Ina Drew, former chief investment officer at the bank, over $23 million, if you include her deferred compensation and unvested shares. Drew oversaw the unit responsible for the large losses and reported directly to Dimon according to the testimony this morning. As in years past, the board gave Dimon and Drew's pay primarily in stock and options-based awards. Those items alone totaled $17 million and $8.5 million in 2011, respectively.

So what really drives their behavior? And what message is the board sending when they pay their executives this way?

This kind of high pay is exactly what a December New York Fed staff report warned could encourage risky CEO behavior and create economic distress. (Ironically, Dimon sits on the NY Fed's board, although a petition for his removal has garnered over 36,000 signatures.)

In contrast, sound compensation guidance from the regulators recommends risk-based measures, which put a company's and its employees' performance in the context of the quantity and quality of the risk that's taken on. Though banks claim to use risk-based measures, stock price is still the biggest determining factor in top bank executives' actual rewards. But goosing a company's stock price and taking rational risks are not exactly close companions. Former CEO Dick Fuld at Lehman Brothers was the poster child for this issue.

MORE: 3 ways to take control of your retirement

Even the measures cited in the proxy for rewarding Dimon and Drew are not risk-based. While a spokesperson for Citi (C) (which received a no vote on pay this year) wrote in an email that "Citi has continued to enhance the ability of the firm to reduce risks through its compensation programs," J. P. Morgan, Goldman (GS), Bank of America (BAC), and Morgan Stanley (MS) declined to discuss their pay practices for this article. No wonder. An October 2011 report by the Federal Reserve confirms that the use of risk-based measures at the large banks is "uneven" and every bank has more work to do. "Substantial work remains to be done to achieve consistency and effectiveness … in providing balanced risk-taking incentives," the report states. Put simply, bank boards need a kick in the pants.

Who will step up?

The FDIC put out an advanced notice over two years ago asking for comments on proposing a rule that would charge banks more for depository insurance if their pay programs were risky. Such a measure could have been a real impetus to fix pay. But, "to date, there has been no follow-up to the advance notice of proposed rulemaking," an FDIC spokesperson recently emailed me. And Martin Gruenberg, acting chair of the FDIC, did not address pay or such a proposed rule in his prepared testimony before the Senate last week.

The Office of the Comptroller of the Currency (OCC) is getting beat up these days. They had staff in London where the J.P. Morgan traders were located. An OCC spokesperson explained to me by email that while their staffers review trading data daily or weekly, "even a strong risk management culture could have surprises or breaks, but they should not be of significant magnitude relative to the banks business." Regarding pay, "the [sound compensation] guidance stands as what the examiners are using to supervise banks."

Last week, in his remarks before the banking committee, OCC head Thomas Curry mentioned "the need to ensure that incentive compensation structures balance risk and financial rewards and are compatible with effective controls and risk management."

Daniel Tarullo testified on behalf of the Board of Governors of the Federal Reserve. But his prepared remarks did not mention compensation. This, despite the fact that the Fed has oversight responsibility for top executives' pay. The Fed's October 2011 report outlines that bank pay "should achieve substantial conformance with the interagency guidance by the end of 2011 (affecting the award of incentive compensation awards for the 2011 performance year), and should fully conform thereafter." Neither the OCC nor Federal Reserve would comment, however, on their examinations and assessments.

MORE: David Herro: Why I'm betting big on Europe

The silence, especially from the Fed, is deafening, particularly since the banks' compensation fixes seem to have been done for only some managers rather than the top executives.

But pay programs for top executives matter most because their motives will influence their instructions and other managers' actions. (While the reverse is not necessarily true.)

The October 2011 report by the Federal Reserve states that incentives "were a contributing factor to the financial crisis that began in 2007." The M.O. among do-nothings is that losing billions isn't necessarily concerning for a bank the size of J.P. Morgan. I don't agree. Just because this isn't the 100-year flood doesn't mean we shouldn't repair the levy. How many breaks will we tolerate until we fix it?

Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance (http://thevaluealliance.com), a board advisory firm.

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About This Author
Eleanor Bloxham
Eleanor Bloxham
Contributor, Fortune

Eleanor Bloxham, an authority on governance and valuation, is CEO of The Value Alliance and Corporate Governance Alliance, an independent board and executive educational and advisory firm she founded in 1999. She is author of the books Value Led Organizations and Economic Value Management: Applications and Techniques, and publisher of the Corporate Governance Alliance Digest and her blog The Bloxham Voice.

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