The normally bank-friendly Fed fired an unexpected shot across the industry’s bow today, taking issue with its failure to take sufficiently tough measures to curb undue risk-taking. Per the Washington Post:
The Federal Reserve has completed an initial review of compensation policies at 28 large banks it oversees and has been giving them confidential feedback on areas where they must change. On Monday, the Fed and other federal regulators issued final guidelines, stressing the need for policies that do not give executives, traders, and other bank employees incentives to make overly risky investments that might earn them huge bonuses in the short run while leaving the bank exposed to losses in the long term.
The press release detailed the areas in which, ahem, improvement was necessary:
* Many firms need better ways to identify which employees, either individually or as a group, can expose banking organizations to material risk;
* While many firms are using or are considering various methods to make incentive compensation more risk sensitive, many are not fully capturing the risks involved and are not applying such methods to enough employees;
* Many firms are using deferral arrangements to adjust for risk, but they are taking a “one-size-fits-all” approach and are not tailoring these deferral arrangements according to the type or duration of risk; and
* Many firms do not have adequate mechanisms to evaluate whether established practices are successful in balancing risk.
Yves here. This emphasis on better calibration of risk, and more differentiation among incentive comp payout structures, would indeed help discourage the industry’s fondness for complex, opaque deals that produce profits now but have hidden risks that can blow up clients and even the firm, later. It might serve to restore the recently-fallen standing of investment banking businesses. If you do an M&A transaction or a corporate underwriting, the risk that the deal team did Something Awful that will leave wreckage in it wake is limited (not zero, mind you, but limited). By contrast, if you are a derivatives salesman, if you sell the sort of complex products that produce juicy profits (and those are opaque to the client), they typically don’t go sour right away.
But one of the problems is I am not certain how you improve the industry’s ability to judge risk ex ante. Pretty much no one at the big firms judged AAA CDO tranches to be risky until it was too late. They had been acceptable collateral for repo and the haircuts were a mere 2-4%. Even after the Bear Stearns hedge funds blew up (July 2007) repo haircuts didn’t start widening (and then only a very small amount) until Sept 2007 (and recall, that was the first acute phase of the credit crisis, when subprime paper was suddenly tainted). Anyone in senior management up through and including the 2006 bonus year would no doubt have contended that CDOs weren’t that risky (80% of the deal was rated AAA, the rest was sold to “sophisticated” buyers). And 2006 was the peak year for CDO issuance, and the overwhelming majority of deals burned investors, and the banks, badly.
The Financial Times focused on the politics:
In response to the backlash against big bonuses, most banks have announced provisions to “claw back” part of traders’ and bankers’ bonuses if their deals cost money in later years…
However, many banks have remained adamant that star traders and bankers would still be rewarded with big pay packages, arguing that a large cut in salary and bonuses would lead to a brain drain from the industry to less regulated entities such as hedge funds and private equity groups.
A senior Wall Street banker said on Monday that the Fed’s moves would compound the political pressure on compensation but added that, in private, the authorities had been more flexible in vetting pay practices and bonuses.
Banks are now bracing for a possible new salvo from Kenneth Feinberg, special master on pay at the Treasury, who will announce soon whether he intends to name and shame banks over specific pay-outs made at the height of the crisis.
Yves here. “Bracing”? Banks have been remarkably impervious to criticism from officials and the media. But the Fed could actually force some changes if it kept the heat on. Given its track record, I would not be terribly optimistic, but then again, I am surprised it has gone even this far. It would be great if it surprised me again.