Mirabile Dictu! The Fed Criticizes Wall Street Pay Practices

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.

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  1. Siggy

    What puzzels me is how first loss tranches can be bundled into an instrument that warrants AAA.

    What confounds me is that the industry continues to pay enormous wages to ordinary people whose apparent performance is currently the result of ZIRP rather than any particular talent or customer book.

    A nine year old can chase yield and/or extract fees from a deal. Create a real enterprise, now that’s worth paying for and how many real new enterprises have been created over the past 5 years?

    Just what makes twitter fritter and flap so valuable? Most of these new gadgets are a waste of time. Nonetheless, everyone is thumbing away . Soon there will be a new injury, cramped thumb syndrome.

    There’s something in the water!

    1. psychohistorian

      Siggy said: “It must be something in the water.”

      Let me correct that,

      It must be something in the TV.

      TV has been an effective tool of propaganda for 50+ years. It was initially touted as this great public service that eventually got compromised into a corporate tool of product and social propaganda.

      The same sort of compromising by big corporations is now being applied to the internet.

      1. Siggy

        No No, TV is furniture or wall art. TV news is like the short subjects before the movie. By the by, haven’t been to a movie house in years. Most new films aren’t worth the effort and the ones that are generally come out as DVDs soon enough.

        There is more information on the net than we’ve ever had before. And even in that, 80% is noise. And that is the result of the fact we have so many people who would like to ban Huckleberry Finn because its racist? Ultimately, it’s all about people. Some are competent, most aren’t. It’s always been that way and unless we have some mutational miracle, it will always be that way. Most people are just plain dumb and too lazy to learn.

        Wall street pay is obscene, I never believed that what I was once paid was appropriate. But then, it did help to create a nice little nest egg despite the pernicious loss of purchasing power that continues to proceed apace.

        In managing money one soon is confronted with the problem of size. It is very hard to achieve superior performance when there are very large sums to be managed. Quite simply instead of being one of thousands in the market, you become the market. Moreover, if you have a secret sauce, because of your size, it is not very long before everyone else mimics your sauce and lo, the exit door is too small for everyone and you get a market collapse. Recall our recent experience with Electronic Thursday.

        I’m confounded by what the Fed is doing and I suspect that they have no idea as to what they are doing. Maintaining zombie banks will not cure the problem and we may well be at end game for the US. It’s like life support for a terminal cancer patient. It’s nolonger a matter of whether, it has become a matter of when.

  2. RueTheDay

    “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.”

    Wait, what? If this is a regulatory mandate, then why is it being kept confidential?

  3. Michael Wasserman

    “… a large cut in salary and bonuses would lead to a brain drain from the industry …”

    Those brains need to be devoted to producing real goods; a drain away from the financial services industry would be a good thing.

    1. Siggy

      Michael, are you a test? Couldn’t resist.

      Indeed, the financial services industry and Wall Street in particular operate as rent extractors as opposed to production creators.

      The only thing a trading firm brings to the market is liquidity. What then can trading firms bring if the world is afloat on a sea of liquidity created out of ink and paper or even more ephemerally by way of electronic pulses, notationally 1s and 0s.

      Well if you can’t bring anything, might as well take something. Comes now to mind the great short. Cobble up a CDO, get a CDS against that little beauty and everything is hunky dunky. How dare you Brooksly, Thank You Robert and Larry, and by the by a hat tip to you dear msrs Gramm Leach & Bliley.

      Could it be that an excess quantity of credit money has led to the commitment of an excess quantity of financial laborers and less than appropriate rates of return that demand the assumption of greater and greater degrees of risk? Could that be our financial cancer?

      Naw, much to direct that.

  4. i

    “…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.”

    Meaning a drain of these geniuses away from the institutions that handle OUR money (i.e. the “little” people in BP parlance) to private institutions inhabited only by large investors playing with their own money.

    Tell me again why this is a bad idea?

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