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Feature

Philip J. Purcell
President
Continental Investors LLC

Reining in the ‘Too Big To Fail’

Let’s see some action on new capital requirements, profit-based compensation, and board control over risk management and pay.

By Philip J. Purcell

Americans have grudgingly supported the use of tax dollars to save the financial system and the economy, recognizing the action as both right and necessary. Unfortunately, saving the financial system required rescuing many firms considered “too big to fail” that individually did not deserve to be saved. Taxpayers rightly resent their money being used to keep these firms out of bankruptcy and, in some instances, to protect the multimillion-dollar compensation packages of the people who caused the crisis.

In short, Americans understand the need to protect the financial system, but don’t want the events of the last 18 months—or anything close—ever to happen again.

So one would think that we would be putting in place changes to prevent future catastrophes or, at least, substantially reduce the cost to taxpayers. But to date, there have been only short-term, stopgap measures.

There are three areas that require attention and where action could be taken right now: new capital requirements, profit-based compensation, and greater board control over risk management and pay.

More Equity Capital
First, equity capital must be increased, particularly for institutions that are “too big to fail.”

Last year regulators shut down over 100 banks that were undercapitalized. Smaller banks are now routinely required to have 8% tangible equity per dollar of assets (the leverage ratio). This much stronger capital structure will reduce small bank failures in the future.

Too big to fail institutions, however, should have a higher ratio of 10% to 12%. This would not put them at a disadvantage, but would only even the playing field. These institutions have an implicit, or explicit, federal guarantee on their debt that lowers their cost of capital relative to smaller institutions, giving them a permanent competitive advantage.

We should also keep in mind that there is a cost to the Federal Reserve safety net, and greater capital soundness reduces the risk and cost. The public bears the cost of too big to fail. Since capital is the public’s main protection, it should be quite high.

The 12% tangible equity requirement should apply to all financial institutions that have the implied federal guarantee, whether they are banks, brokers, insurance companies, industrials, or government-sponsored entities.

Any institution that does not want to be too big to fail can shrink in size through sales and spin offs and be eligible for the lower leverage ratio. No institution is forced to be too big to fail.

The Right Compensation Policies
Second, regulators and boards should put in place compensation policies that will strengthen capital and discourage reckless risk taking. The efforts of President Obama’s pay czar, Kenneth Feinberg, have provoked a fair amount of consternation. One problem is the lack of any standard. How do you decide if a given amount of pay is too much?

Regulators are not in a position to decide individual compensation, whether it’s salary, bonuses, or incentives. That is the job of management and the board of directors. But regulators should look at overall compensation as part of their responsibility to make sure an institution is financially sound.

The best way to do this is to focus on total dollars of compensation paid relative to total pre-compensation profits. For a profitable too big to fail institution, capital should never fall below 12%. Therefore total compensation should never exceed pre-compensation profits. To do otherwise amounts to looting the company’s capital and, as we’ve seen from recent experience, endangering the company’s very existence.

As a general rule compensation should not exceed 75% of pre-compensation profits without prior approval of both the board and the regulator. This would ensure 25% of pre-compensation profit goes to strengthen capital, reward shareholders, and pay taxes.

Few would argue with regulating excess total compensation in order to keep institutions financially strong.

Too big to fail clearly does not mean big enough to pay competitive compensation in order to stay alive despite poor performance.

This also implies the regulators will not need to look at individual compensation (salary or incentive); the regulator needs to ensure the institution is financially sound, not that it is paying the right amount of compensation to each or any individual.

Role for the Board
Third, boards must take responsibility for viewing compensation in the context of risk management. As a first step, compensation committees and risk management committees should be merged into one committee so the members understand the risks taken to generate revenues and compensation based on revenues. With knowledge of the risk management processes and the long tailed risks at every financial institution, boards should be in a stronger position to weigh in on compensation issues.

In addition to the rule that total compensation can never exceed pre-compensation profits, boards would do well to consider at least two additional policies. First, individual compensation over $500,000 would be delivered in restricted common stock. And second, the receipt of common stock would be restricted for three to five years, and only delivered if that firm remains profitable.

All of these steps could be implemented almost immediately. Not to take them will leave our financial system, and the economy, at an unacceptable level of risk.

Philip J. Purcell is president of Continental Investors LLC, a private equity firm founded in 2006 that invests in private companies primarily in the financial service industry and in consumer businesses where the Internet is important.

Prior to forming Continental, Purcell was chairman and chief executive officer of Dean Witter, Discover & Co. from 1986 until the firm acquired Morgan Stanley Group Inc. in 1997. He served as chairman and chief executive officer of Morgan Stanley until his retirement in 2005.

He joined Sears Roebuck & Co. in 1978, coming from the Chicago office of McKinsey and Co., where he was the managing director. While at Sears he was the driving force in its decision to acquire Dean Witter and Coldwell Banker. His accomplishments at Dean Witter include the creation and successful launch of the Discover Card in the mid-1980s.

He serves on the board of AMR Corp. and American Airlines and is a trustee at the University of Notre Dame, where he chairs the athletic affairs committee. He was the founder and chairman of the Financial Services Forum, an organization comprising the CEOs of 20 major financial services firms. He served on the board of the New York Stock Exchange and was elected vice chairman in 1995 and 1996 and later served on the executive board of the NYSE.

He can be contacted at phil@continv.com.