Financial Sector Compensation and Governace Reform

I think this is an interesting issue that has to be framed correctly for those making the case for compensation reform. Here is my take on how to frame it:
This shouldn't be so much about "compensation caps" as it is about aligning compensation with risk, especially systemic risk. I think if one is able to frame it like that, the nature of the debate changes to one of risk management and away from charges of "government -interference in pay"


Taleb (author of the Black Swan) has alot to say about the problem of the "deferred blow up" strategy where traders can take outsized risks that have "low frequency, super high impact". An employee can take these outsized bets and make reap huge gains for several years until a big blowup occurs. The blow-up is so big it can bring the entire firm down or even the entire system down. In such an event, the employee is effectively getting a free Put option, as their upside is unlimited, but the down side is only limited to his/her job and perhaps the current year bonus, as their is no recourse for the past bonuses. Here we've got a problem of ill-gotten gains.

There is no mechanism to guard against systemic risk. One could argue that this is a corporate governance / shareholder issue, and in part it is. Here, there might be a case that shareholders need more governance and risk tools at their disposal. At this point, the administration is focusing on this as a shareholder rights issue, which politically is probably the best way to start, as it enlists institutional investors as allies in the cause.
However, I would eventually go even further, as even shareholders are not going to be guardians of systemic risk, as their obligations are to protecting common equity portion of the balance sheet, not systemic risk.For instance, shareholders themselves might be tempted to allow risks that are "very low frequency, very very high negative impact" where these negative impacts are several times the value of common equity but supposedly only occur once every 50 years. In such an instance, they too are being given a "free put option", as they reap the outsized gains from the outsized risks, but do not bear the full costs if a blowup were to occur.