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Fed Plays Politics on Banker Pay

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The Wall Street Journal has a headline that would warm the cockles of any populist’s heart: “Bankers Face Sweeping Curbs on Pay.” And even more impressive, who is going to rein in banker compensation? The Fed.

That alone should tell you there is less here than meets they eye.

Let’s look at the outline of the idea:

The Fed’s plan would, for the first time, inject government regulators deep into compensation decisions traditionally reserved for the banks’ corporate boards and executives.

Under the proposal, the Fed could reject any compensation policies it believes encourage bank employees — from chief executives, to traders, to loan officers — to take too much risk. Bureaucrats wouldn’t set the pay of individuals, but would review and, if necessary, amend each bank’s salary and bonus policies to make sure they don’t create harmful incentives.

Let’s parse what is happening.

First, despite the bold headline, this is not a done deal. While the Fed does not need approval to implement this idea, the proposal is weeks away from being fleshed out. Expects gnashing of teeth and tons of pushback from industry lobbyists. Whatever has been leaked will probably be diluted. Recall what happened to the stress tests, where the big banks managed to beat back the regulators on many key issues.

Second, the timing seems awfully sus. Ron Paul’s “audit the Fed” bill now has enough votes so as to be veto-proof in the House. The G-20 meeting are also sure to include discussions on how to curb banks. Europeans are particularly keen to put limits on financial firms, the countries with big financial centers, the US and the UK, predictably less so. Moreover, the Fed can always argue to go for whatever the lowest common denominator is by international standards (resorting to the usual excuse, “if we are more toughminded, the banking ‘talent’ will all leave”). So this looks like a cynical effort by the central bank to burnish its image.

Third, as a result, it is hard to believe the central bank’s heart is in this. The Fed has thrown an extensive safety net under the banking industry and has proposed zero in the way of measures to combat the moral hazard and bad incentives creative by such massive subsidies of risk-taking. They’ve been shockingly unprepared to deal with this issue. Now we have a leak that action on the pay front is forthcoming, but the proof of the pudding is whether the Fed would do anything more than implement a few obvious measures, like mechanisms to claw back pay under certain circumstances.

The problem is, despite the swashbuckling talk in the Wall Street Journal story, the ideas on the table suggest any moves will directed at the most extreme practices, simply to curry the image that the Fed is Doing Something. The proposed measures are not extensive or intrusive enough to deal with the fact that we now officially have a system of socialized losses and privatized gain. That arrangement calls for heavy, intrusive oversight to curb risk-taking of crucial, social valuable banking and capital markets functions, managing them as a utility. Those regulated institutions would also need to be restricted from extending credit for financial or investing activities that were not deemed socially valuable (that means, for instance, no prime broker loans, hedge funds would have to get their leverage via exchange traded instruments or non-bank affiliated creditors).

But what we see instead is:

The U.S.’s largest banks, about 25 in number, would get especially close scrutiny. The central bank intends to compare these banks as a group to see if any practices stand out as unusually dangerous to their firms.

This group is apples and oranges. The risk-taking that was really troublesome and hard to police took place at the big capital markets players; the former investment banks plus Citi. If you believe Gillian Tett’s Fool’s Gold, JP Morgan was more prudent by virtue of having a more conservative culture on risk, and then later, Jamie Dimon, although a cynic might say their caution was due to taking big losses on credit default swaps in the Ford and GM downgrades in 2005 (I think 2005, forgive me if 2004), which was a painful but in the end very valuable reminder. But the same issues apply to JP Morgan.

How is the Fed going to curb risk when for well over ten years, it has refused to understand where risks in complex organizations lie, instead relying on their own risk models (recall in the infamous stress tests, the Treasury asked banks simply to run scenarios, and the Fed has proposed institutionalizing the stress test approach, with NO suggestion that the Fed develop its own models for measuring the risk on bank books). For instance, banks blew themselves up last cycle on AAA rated instruments precisely because regulators allowed banks to carry very little capital against them (Basel II banks even got to assign their own capital, which they generally decided was zero if they hedged the risk with a credit default swap).

To wit:

The proposal will likely push banks to use “clawbacks” — provisions to reclaim the pay of staffers who take risks that hurt their firms — in certain pay packages, among other tools, to punish employees for taking excessive risks with their firms’ money. The central bank could also demand that more pay be offered through restricted stock or other forms of long-term compensation designed not to reward short-term performance.

This all sounds well and good, but the use of restricted stock has proven wildly ineffective in curbing a short-term focus. Bear and Lehman had very high levels of employee stock ownership across the firm, and look how much good that did in curbing their risk taking.

But in a way, that is irrelevant. One of the effects of any rules like this is Morgan Stanley and Goldman will ditch their bank holding company status, pronto. Even this level of intrusion is more than they will want to deal with.

By contrast the risk taking at traditional banks (yes, we do remember that Countrywide, IndyMac, et al blew themselves) could and should have been managed through bank examinations. A lot of the people at those banks, as reports have dribbled out in the media, were kept from reining in the reckless practices at these banks not by being bribed (rich pay) but by the mundane threat of job loss if they did not play along (this in particular applies to roles that are not richly rewarded and are designed to check the sales types, like appraisers and compliance).

So again, we have symbolism and probably some action on a few outliers, but otherwise business at usual wrapped in a reform banner. Welcome to corpocracy in America.

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12 comments

  1. Swedish Lex

    Yves,

    The EU leaders agreed on their G-20 position last night. Here is the compromise text on remuneration that the Swedish EU Presidency will be brining with it to Pittsburgh:

    Promoting responsible remuneration practices in the financial sector;

    15. The G-20 must fulfil the commitment subscribed to in London on pay and compensation to encourage sound risk management and a strong link between compensation and long-term performance, while ensuring a level playing-field.
    16. In particular, the G-20 should commit to agreeing to binding rules for financial institutions on variable remunerations backed up by the threat of sanctions at the national level, covering the following principles:
    a) enhanced governance to ensure appropriate board oversight of compensation and risk;
    b) strengthened transparency and disclosure requirements;
    c) variable remunerations including bonuses to be set at an appropriate level in relation to fixed remuneration and made dependent on the performances of the bank, the
    business unit and the individuals; taking due account of negative developments, so as to avoid guaranteed bonuses; the payment of a major part of significant variable
    compensations must be deferred over time for an appropriate period and could be cancelled in case of a negative development in the bank’s performance;
    d) prevent stock options from being exercised, and stocks received from being sold, for an appropriate period of time;
    e) prevent directors and officers from being completely sheltered from risk;
    f) give supervisory boards the means to reduce compensations in case of deterioration
    of the performance of the bank;
    g) explore ways to limit total variable remuneration in a bank to a certain proportion either of total compensation or of the bank’s revenues and/or profits.

  2. MrM

    “One of the effects of any rules like this is Morgan Stanley and Goldman will ditch their bank holding company status, pronto.”

    Have there been any precedents of bank holding company withdrawing its BHC status? Is there an established process to do so? I think the answer to both questions is no. Besides, the political ramifications of such move would be quite large. I doubt this is a viable option in the near term. It is much easier to work with the Fed behind the curtains while keeping all the appearances…

  3. Siggy

    The preoccupation with banker compensation seems to be a mis-direction. Excessive bonuses flow out of an excess quantity of loanable funds and unregulated derivatives trading.

    We are drowning in a sea of credit money (debt) and the Fed and the Treasury are throwing money at the problem. Joint and several liability is incarcerated behind the corporate veil. And those whose brief is to regulate financial activity have taken the course of abrogation of duty in the name of the ultimate canard that markets are inherently efficient and that prices are always rational.

    Several of our trading partners are making noise about a better reserve currency. Yet they are all too happy to sell us their manufactures and in the process they are lending us the credit money that we need to buy their goods.

    A banking community that has a fiat currency and fractional reserves as the keystone of its financial system is inherently prone to excess. Governmental excess exponentially breeds puiblic excess. Lets begin with the premise that no institution is too big to fail!

  4. DoctoRx

    The idea of Taleb and others to separate depository (vanilla) banking and gambling/investment banking allows this issue to be dealt with simply. On the former account, Taleb would have the true banks (depos insts) be Govt-owned. I could also see them treated as do regulated utilities.

    The other stuff remains unregulated. And simply ban the creation of new CDS’s.

  5. Skippy

    @Siggy,

    Have you considered that the government in part, is baling out its self, due to intermediary’s investing on their behalf?

    Skippy…would explain a hole lot…eh

  6. thekingofcheap

    Yves, I saw this blog post yesterday and thought you would really enjoy it here at Naked Capitalism. It came up at Slashdot and looks at US corporate culture through the prism of “The Office.” The writer calls it “The Gervais Principle.” It seems relevant to a post about CEO compensation and destructive practices at the top of the corporate ladder. Hope you read it! Would love to know what you think

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